Common financial planning advice has it that the first step in any financial plan is to develop what is usually referred to as your “Emergency Fund”.
The reasoning behind this is entirely sound.
One should first save up 3-6 months of expenses in cash that should be held in cash, ready for you to tap into in the event of any financial emergency.
However, on the face of it, this advice seems to go against the idea that one should always deploy capital to work by investing into productive assets.
Indeed, the only guaranteed way to lose money is to hold cash in a bank account*
However, the common advice given by most financial planning instructions is to establish this pot of savings, and then ring fence it in a liquid cash account protected from being invested or used to cover any day-to-day expenses.
If you are just starting out in getting your personal finances in order, it can seem very frustrating to save, and save, only to lock up this cash out of sight, and not invest it into something that is going to deliver you a return on your money.
Especially when, as we all know, the sooner you start investing your money the sooner you can start to benefit from the effects of compounding interest.
Risk Management
The reason for this is very clear.
Risk management is a very large part of wealth management and is at the core of most decisions we make when managing our finances.
We hold widely diversified portfolios of assets, in order to mitigate against the effects of unsystematic risk in the markets. If a company goes bust, then we are protected by having only a small fraction of our portfolio exposed to that company and by owning shares in the large rival companies that will benefit from the removal of a competitor in the market.
Wherever possible, we can identify and diversify away unsystematic risk through the assets we hold.
However, systematic risk is something that is much more difficult to hedge against without impacting on the expected returns (TANSTAAFL!)
However, the Emergency Fund is not designed as a slush fund to tap into to buy up assets following a price crash. Nor is it designed as a cash asset diversification for your portfolio.
The fact is, the Emergency Fund is the buffer that protects your investment portfolio from the need to be liquidated, or reduced, in the event of a financial emergency in your day-to-day life, and this is the reason it is regarded as essential to establish before you establish your investment portfolio.
Financial Emergencies
Regardless of how cautiously you manage your affairs, accidents can and do happen in the course of a lifetime.
So what do we mean by “Financial Emergencies”?
These can be anything, but common examples include:
- Unexpected vehicle repairs or maintenance
- Unexpected household repairs or maintenance
- Unexpected medical bills.
Imagine a scenario where our plucky protagonist is living overseas, married with two children and a car.
All is going well, until his car breaks down one day on the way to work, on the same day that the A/C unit in his house grinds to a halt, and his daughter falls sick requiring medical care outside of their health insurance coverage.
Whilst this is something of a perfect storm of problems, and a great example of “Tucker’s Law” it would certainly lead our hapless chap to require a large amount of liquid cash on hand to cover these expenses.
If our luckless friend has deployed all of his money into his portfolio, in pursuit of optimizing his returns, then in the short term he will find himself in something of a liquidity crisis.
In order to pay these sudden bills, he would be forced to sell off some of his assets to free up the cash.
Importantly, he would be forced to sell off assets, under duress, regardless of their value in the market at the time.
This is the important point.
Without the Emergency Fund to cushion the impact of unexpected bills, external factors can force you to take an action to sell off part of your portfolio that you otherwise would not have sold.
That is to say, your investment planning is negatively impacted by non-market factors forcing a change in holdings.
Given the terrible luck that our protagonist has, we could easily assume a situation in which all of the above financial emergencies happen immediately following a severe stock market collapse or other financial crisis.
In this case if we imagine that we purchased an asset immediately before a stock market crash and faced these emergency bills just after the crash, the absence of an Emergency Fund would force you to sell low, assets that you bought high, the worst possible scenario, because you have no other option to meet your immediate obligations.
In this case, then, it is clear that the “missed returns” that one takes on the Emergency Fund cash held as cash, is the opportunity cost that is paid in order to protect yourself from being in a situation that you have to sell assets for below the price you otherwise would.
Smarter Emergency Funds
The importance of an Emergency Fund, then, should be abundantly clear, and it certainly is the first priority to develop before your investment plans, and replenish before adding to your investment plans if you have tapped into it.
An Emergency Fund should be maintained at all times.
But, if we break down the uses of an Emergency Fund, it becomes clear that by utilizing lines of credit we can reduce the amount of liquid cash we need to hold to meet our EF requirements.
With the smart use of credit we can essentially employ a system of “fractional reserve” on your EF and allow you to put most of it to work in a productive investment vehicle, with a few important distinctions.
The first thing to realize is that, for most intents and purposes, credit is as good as money.
When you buy a pint of beer at the bar, the bar does not make any difference if you pay with cash or on your credit card.
In this sense, credit and cash are identical.**
Now, for the most part, most banks are also going out of their way to try and entice you to take out a credit card with them!
Typically, the billing cycle of credit cards will leave you with anywhere between 30-60 days from the point of purchase until you are required to cover the credit card bill, or face interest charges in the balance.
That is to say; your credit card is essentially an interest free line of credit for 30-60 days.
Provided you pay off your credit card bill in full, on or before the due date, you have up to 2 months to cover any costs you run up on it, including any unexpected financial emergency bills.
From personal experience, I have previously held a single credit card with credit limit of just over $20,000 USD, which at the time was enough to cover more than 6 months of my average monthly expenses.
That was one single card, from one single bank.
If we sit down and run the numbers, and we decide that we would be happy with an Emergency Fund of $6,000 USD that would provide an adequate buffer to our investments and will cover any unexpected bills with a large degree of confidence.
We can then say that we should perhaps keep $1,000 in liquid cash in an account, and place $5,000 into some very low volatility, low risk, investment.
Short term U.S Treasury Bills are often referred to as the safest of all investments, and used as the base-mark “Risk Free Rate” in financial calculations.
For example CBU7.L is an EU domiciled ETF that trades in USD on the London Stock Exchange, that tracks 3-7 Year U.S Treasury Bonds. It’s low volatility and a fairly steady moving fund.
In the event of any unexpected bill, that is over $1,000, one can simply pay the bill using the credit card and spend the next 30-60 days liquidating the holding you have in your low risk fund (such as the one above) and transfer the money to pay off your credit card bill before it comes due.
By doing this, we can have the best of both worlds.
- Immediate liquidity to pay any unexpected bills
- Cash put to work in productive investment
The crux of this whole idea essentially hinges on the 30-60 days of interest free credit that is offered by the credit card that allow us to hold a fractional reserve Emergency Fund.
No longer does holding a EF require that we leave large sums of money languishing in a current account, being slowly eroded by the power of inflation!
*Current accounts pay below the rate if inflation and as such the purchasing power is eroded.
**For the consumer, the merchant pays a premium for receiving CC payments.