Emergency Fund: In Good and Bad Times

The ability to cover unexpected emergencies is the main reason why everyone should hold sufficient savings in an emergency fund. However, it doesn’t matter for what purpose the money will be used. You can also use it to take advantage of opportunities.

Not living paycheck to paycheck comes with an extra degree of freedom. It makes it a whole lot easier to consider changing jobs if you despise your current one. Do you have a great idea and want to start your own business? Having enough cash in your account will surely help.

However, you can also utilize the emergency fund (or at least a part of it) in investing. During the next stock market decline, you can invest some of your saved money, while everyone around you will be panicking and saying that the end is near. In the long run, any decline in financial markets is an excellent opportunity to buy. Over the next few months, you can gradually rebuild your emergency fund.

How Much and Where?

It is generally recommended to hold an amount worth 3-6 months of your household expenditures. To obtain it, sum up all your monthly expenses (mortgage, utility bills, food, car-related expenses, loans, insurance, etc.) and multiply the result by 3 to 6, depending on the amount of coverage you perceive as adequate.

The optimal personal finance solution is usually different for each individual, and emergency fund is no different. If you have a stable job in a prospective industry which allows you to land a new job easily if you get fired (doctors, IT specialists, etc.), there is no need to hold too much cash.

On the other hand, if you work in fields or occupations that could be greatly threatened by the next recession (car manufacturers, bank clerks, etc.), you should be more cautious and save up a larger cash buffer.

This money must remain available at all times. However, your current account is not the ideal place to store your emergency fund. It would be too easy to slip and spend it on everyday expenses. Who wouldn't be tempted to buy a new wardrobe piece, a better phone, or go on a more exotic holiday when you have a few thousand euros in your account to spare?

Instead, set up a separate (ideally saving) account for this purpose. Most banks now offer the possibility to open one or even more savings accounts free of charge in addition to a current account. However, beware that depositing money into such accounts will not yield any return. After all, it's not their purpose to serve for wealth building.

The emergency fund that you hold in your bank account is a form of insurance, not an investment. And do you know what insurance does? It costs you money. Whether in the form of a direct payment to the insurance company or, like in this case, in the form of lost returns and erosion of value due to inflation.

Consider Investing a Part of It

Most people keep their savings in current accounts where inflation erodes 2-3% of their value each year. One euro held in a current account for 10 years thus loses one third of its original value over an average decade.

Therefore, holding too much money in your bank account is vastly unprofitable, especially when you consider the possibility of investing a part of your emergency fund. For example, a conservative portfolio composed of 50% equities and 50% bonds is capable of generating attractive returns in the medium and long term. Over the last 5 years, it would earn approximately 4.8% per year.

Even a portfolio composed of 30% equities and 70% bonds would have earned you almost 3.2% per year over the past 5 years, beating inflation and preserving the purchasing power of your emergency savings.

Start at the Beginning

Wealth means freedom. Freedom to change job, housing, or to solve everyday problems without much stress. If you have emergency savings set aside for this purpose, potentially disastrous events will turn into mere inconveniences that do not pose a substantial threat.

At the same time, an emergency fund is the foundation for building long-term financial wealth.

Although a proper investment must be long-term, investing for long periods without having a short-term reserve is nonsense. You should only start saving for retirement, children, or better housing after creating your emergency buffer.

You want to avoid a state where you lose your job due to a crisis and find yourself forced to withdraw money from investment accounts right at a time when the markets are in a temporary decline. The emergency fund doesn't only protect you, it also covers your long-term investments.

If you do not have an emergency fund yet, start saving at least 10% of your net income as soon as possible. In one year’s time, you will save 1.2 times of your monthly salary and in less than 3 years, you will create a reserve of almost four monthly net salaries. Don't postpone it until later, it might be too late by then.