You Don’t Need Cash
One of the first things most financial planners will tell you is that you need about 6 months of cash on hand for emergencies. But, if you have discipline, there is no need for you to keep cash on hand. In fact you would be better off not following their advice.
For example, my wife and I spend about $3-3.5K per month. In order to have 6 months of expenses on hand we would need to have $20K of cash on hand.
Let’s assume that we could earn 4% in a money market account (currently above the best rates at Bankrate.com) and an average of 8% in the stock market (below the historical average of 10%). In the first year we would accumulate an average of $800 more investing in the stock market than in a money market account.
Due to the magic of compounding the difference is much larger the longer the strategy is followed. For example, the annual difference in the 5th year would be $1241 and $2060 in the 10th year.
Even though the differences in percentage return seem small, over a long period of time, the effect on your net worth can be substantial. In 20 years, the initial $20K investment would be worth $44K if you were to invest it in a money market account versus approximately $93K if you were to invest it in the stock market.
However, if you know that you do not have the self-control to keep lines of credit available for emergencies, then you should not follow this strategy!
In the past, I have recommended this strategy to friends but they have decided to keep extra cash on hand. I think the thought of having cash is too comforting and the thought of debt too frightening for most to consider using this strategy. But this is a long term strategy that has been very rewarding for us and could be very rewarding for you.
Additionally, the same strategy has been advocated by Jonathan Clements, a columnist for the Wall Street Journal, in his book, 25 Myths You’ve Got to Avoid - If You Want to Manage Your Money Right:
So how will I pay for my emergency? If I put my mind to it, I figure I can get my hands on a fair amount of money fairly quickly by tapping credit cards, the equity in my home and the money in my company’s retirement-savings plan. I will borrow money to pay for the emergency and then pay off the debt either out of my paycheck or by selling stocks after the market recovers. Borrowing money is clearly costly. But over the long haul, the superior returns from stocks should more than compensate for any short-term borrowing costs.
Apprentice said,
September 6, 2005 @ 9:11 am
I also disagree with the standard convention that 6 months of expenses need to be kept in a liquid account. An emergency fund, to me, should be reserved for dire straits. I have a goal of setting aside 3 months of expenses in a separate brokerage account as monies I can access in 3 - 5 days. I am keeping a slush fund of $1,000 for smaller emergencies in a savings account, and feel that this should be enough to sustain us in the 3 - 5 day interim.
I’ve also recently been unemployed for two long stretches (nine and seven months) in a 24 month period. In each case I did not have to dig into savings.
So, I would recommend a staged approach for emergencies. A small line of credit as overdraft protection, a slush fund for day-to-day “emergencies”, and a true emergency fund that can be liquidated and accessed in 3 - 5 business days.
Note: I disagree that emergencies should be funded with a line of credit.
Apprentice
cashchecksandbalances.com
» Carnival of Personal Finance #12 by Blueprint for Financial Prosperity said,
September 6, 2005 @ 1:30 pm
[…] Want a reason not to save six month in your emergency fund? Financial Reference gives some good reasons why that is too much. He argues that having that amount in lines of credit is sufficient in most cases if you have the discipline… read on to hear the argument. […]
baselle said,
September 6, 2005 @ 11:31 pm
Aren’t you forgetting human nature? Your plan is fine for you, because apparently you aren’t jumpy about your investments (you’re planning on an 8% average rate of return - my rates of return tend to be lumpy), your sense of timing is superb (your emergency doesn’t correlate with a sharp investment down turn), you have the discipline, and your line of work is a hot one, with little outsourcing and loads of choices.
All of those ingredients are woefully lacking in 90% of American households.
That being said, once you decide on the size of an emergency fund and fund it fully, its time to invest. I think one can have too big an emergency fund if one is the sort to believe that a six month emergency fund gives one six months of stalling.
Brian said,
September 7, 2005 @ 8:55 am
My point is not that I will be better off in all circumstances — but that, chances are, I will be better off. I think it’s reasonable to expect an average return of 8%. Of course, this 8% is “lumpy” — I could have to cash out at the bottom in a worst case scenario. But, the probability of that happening is very small — especially if you own a well-diversified portfolio and, over time, you become overcapitalized through your higher returns.
Of course, if you are in a very cyclical industry, fear that you may be fired soon, and won’t be able to find another job soon you should keep more cash on hand.
There is no certainty in the strategies I recommend — there is risk. However, the upside is much bigger than the downside and has greater probability of occuring. I think that makes the strategy a good one.
On a side note: I couldn’t agree more that people need to understand themselves and their individual circumstances before they undertake any strategy. Thanks for your comments.