Tuesday, October 16, 2007

defying cash emergency funds

An often discussed topic in the personal finance blog world, is emergency funds, and whether they are necessary or not. I'd like to start by stating that I believe this is at its core a personal choice, and it really does depend on several factors including your financial knowledge, financial situation, comfort with debt, and life situation. The conventional wisdom that one will read from several trained financial minds is to keep anywhere from 3 months living expenses to 1 year's salary in the form of cash, emergency funds. When I say cash, I mean just that, the paper stuff that sits in a bank and hopefully earns interest of some percentage. Right now interest rates on cash balances being paid to most Canadians on their savings probably falls in the 2.0 - 4.5% range. The higher end is typically sought out by knowledgeable and attentive savers that use alternative institutions such as PC Financial or ING direct to store cash.

Without doing any research on the topic, I would venture to guess that there is a great majority of Canadians that right now are holding emergency funds in one of the big five bank savings accounts which will probably pay you towards the lower end of the 2.0 - 4.5% range. Or perhaps even worse, some Canadians are probably holding significant savings in cash form within chequing accounts and low interest savings accounts that would fall below the 2% lower limit in the range. Your personal definition of risk, also comes into the equation in the 'emergency funds' decision. It is important to remember that risk is not always defined as probability of major loss. There is risk in everything including the risk of the large opportunity cost associated with one's money earning 0.5% per year after taxes.

For our personal situation I am not a believer in emergency funds being held in cash for the following reasons (among others):

1 / My wife and I both have relatively stable full-time jobs with companies who have employed us for greater than one year. My wife's with a successful private company with strong government ties, and I work for a $8 Billion public Canadian corporation.

2/ We own a non-registered investment portfolio consisting of mainly large-cap, stable, Canadian and U.S. equities. The value of this portfolio is greater than 1 year's living expenses.

3/ We live below our means and have a debt: asset ratio of 0.57. We are able to live on one of our salaries alone.

4/ We own a ~$20,000 car, and lease one other

5/ We own significant registered investment portfolios

6/ I have above average financial knowledge and comfort level with debt

7/ We have access to a $35,000 unsecured line of credit at a reasonable interest rate (~ 8%)

For me, each one of the above factors provides some type of advantage in an 'emergency' - type financial situation. With these all taken together, the concept of having an emergency fund seems unnecessary to me. In fact I feel that it would be a shame to have my money growing at a rate barely beating inflation or perhaps declining in value over time, after the impact of inflation and interest tax.

What would I do in an emergency?

Well, it really depends on what type of emergency we are talking about. Generally I would evaluate the situation and adjust my balance sheet accordingly to account for the current impact of the emergency, and/or future impact of the emergency. Using debt would not be my preference, however given certain circumstances where future income would be known, debt might be an attractive option. Liquidating my non-registered investments to protect against the emergency putting us into some type of debt would be painful, but if pressured I could rationalize the sale of one or two of our equities to serve this purpose.

Just off the top of my head I can think of some life situations and environments when one might need a cash emergency fund. These are:

1/ I just started my own business and I have quite a bit of debt.

2/ We are a one-income household with a large mortgage, 2 kids and no investments of any kind.

3/ I work at a company that has been downsizing for years, I have lots of debt, and my wife makes less money than me.

Obviously there are several variations of the above, as well as other situations where a cash emergency fund may be necessary as well....

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10 comments:

Anonymous said...

I couldn't agree more.

I still have too much cash but I find that it's hard to budget accurately enough so that I don't need to keep any extra cash around.

Mike

FourPillars said...

Sorry, my finger slipped and the comment got posted before I could enter all the data.

Speaking of which - can u add a comment plugin that doesn't require commenters to re-enter all their info each time?

Potato said...

"When I say cash, I mean just that, the paper stuff that sits in a bank and hopefully earns interest of some percentage."

I _used_ to keep actual _paper_ cash hidden away for emergencies (the sock drawer returns no interest, unfortunately). I figured it would only be for the real emergencies where no type of debt, credit, or cheque would do. The town is flooded and the only guy with a boat wants cash type emergency (or, a common use of that money: I'm too tired to move and the pizza guy won't take visa).

I say used to because my house was broken into and when $400 in cash took a walk, it suddenly seemed like a dumb idea (and just recently, the pizza place has started taking credit cards if you warn them in advance :).

Other than that, I usually keep 1-4 months worth of rent & groceries in a savings account, just in case someone loses their job or a large unexpected expense comes up. That same high-interest savings account tends to get slowly filled with any monthly savings until there's enough there to pick another stock to invest in for the long term, but even when I move money from it to the broker, I keep at least enough money to cover rent and food for a month.

Beyond that, I tend to agree with you, if anything more disastrous happened and I needed more money, then I'd have to go into debt or liquidate some stocks, there's little point to keeping more cash than that at the ready. Faced with that choice, I think I'd take selling shares (even if I had to do so at a loss) rather than go into debt. The only time when I can really see needing more than a month or two of a cash emergency fund is when the investment portfolio has very poor liquidity.

telly said...

I'm with you again on this one MG. Our reasonings are:
1) MOST important - unsecured LOC at 7.5%
2) my husband and I have ~ equal incomes but we essentially live off one (if required), not including investments which we could postpone if need be.
3) we make substantial pre-payments on our mortgage that could be stopped at any time (also we could miss payments without penalty due to having made the significant pre-payments if necessary).

One thing I'm unclear on is how #4) is a reason for not keeping cash emergency savings?

t h rive said...

i'm pretty sure he means selling the car as if it were a liquid asset?

like you, i keep a minimal cash buffer in my savings...call it a buffer rather than 'emergency funds'. in an actua-emergency i'd not think twice to liquidate stock positions, and in that case it's as little as 3 days to cash.

MG said...

Mike, I'd love to, how do I go about adding that?

Regarding the car, that is exactly my point. The car is just another semi-liquid asset that could be sold to have cash in hand if the circumstances fit.

Thanks for all the comments.

vishnu said...

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Brip Blap said...

It's very interesting to me that basically you're saying that an emergency fund doesn't need to be totally liquid. I won't argue with that - in today's world a TRUE emergency would be covered with a credit card, which usually has 30 days to be paid off before the insane rates kick in.

I admire your discipline. I have about 6 months' salary in a high-yield (5.5%) savings account and the peace of mind that gives me is worth the loss in return - to me. It's always interesting to hear the counterpoint, though!

Anonymous said...

For Canadians a large emergency fund is not as necessary as for Americans, because we have universal health care. Also, if I lost my job I'd qualify for Employment Insurance and I know how much it would be and it would cover my necessities.

MG (moneygardener) said...

very good point anon. Another way to say this is that with our social programs here in Canada an 'emergency' is less likely than it is for U.S. citizens.