How Important Is An Emergency Cash Reserve?

What Is The Purpose Of Having An Emergency Cash Reserve?

When there is a leak in your home, it's important to act quickly to minimize the immediate damage before you can deal with the source of the issue. Having an emergency cash reserve works the same way as a bucket would to contain the water from a leak.

There are two key functions that your emergency cash reserve serves:

1. The ability cover your living costs in case of unforeseen events

It is not easy to plan for unexpected events, but most people are happy they did when something unexpected happens.Common situations where you would rely on your emergency cash reserves include job loss, medical bills, car repairs or property damage such as flooding.

Having enough money to cover your short term needs gives you the peace of mind that you can handle a bit of turbulence. The more you have in your reserve, the longer you will be able to sustain something like job loss without severely impacting your quality of life or long term financial goals.

2. Having the access to your money to deal with immediate issues

Some people might say: "even if I lose my job, I will have enough assets to survive for the rest of my life". That may be true, but access to your money (or liquidity) is just as important as how much you have.

The more obligations you have, the more important it is to have quick access to your money. It is more important for someone who owns a few rental properties with mortgages to hold more of their funds in shorter term assets compared to someone who is only spending from their salary.

As as example, someone with higher expense obligations should be holding a higher portion of their emergency reserves in 30 day Certificate of Deposits (CDs) as opposed to 90 day CDs.

How Much Should I Have In My Emergency Cash Reserve?

People generally agree that your emergency cash reserve should cover between 3 to 12 months of your basic living expenses. This is not a universal rule, but only a general guideline.

Depending on your job, business, lifestyle, financial obligations or goals, your emergency cash objectives should be tailored to your situation:

• If you don't want job loss to impact your investment goals, you may decide that your emergency cash reserve should be 6 months of your income rather than 6 months of your expenses.
• Alternatively, you want to maintain your current lifestyle and decide that it should be 6 months of your current living expenses instead.
• If you work in an industry where it take's a long time to find a new job, covering just 12 months of your living expenses might not be enough.

On the other side of the coin, this doesn't mean the more you have in emergency funds the better. While this holds some merit, this could mean you are holding too much in low yield assets. Which also means you are not investing your money optimally and forgoing higher return.

If your family has two sources of income, holding 2 whole years worth of expenses in cash would be overkill. It would be much better over the long run to have some of that invested into stock market.

Regardless of your circumstances, plan your emergency cash reserve in terms of percentages of your expenses and income, rather than absolute dollar amounts and always adjust accordingly.

What Investments Should I Keep In My Emergency Cash Reserve?

We know that your emergency cash reserve should be kept fairly liquid where a significant portion of it (at least 3 months worth of expenses) can be withdrawn immediately.

Don't let the name fool you though. Your emergency cash reserve doesn't all have to be held in cash. If you are building a larger emergency reserve, the more you should consider portioning it out into liquidity periods.

Suppose hold 12 months worth of expenses in your basic savings account. Instead considering partitioning that into money market instruments that can be withdrawn at 3 months, 6 months and 12 months which each offer higher yields.

Here is a list of financial instruments which you should consider other than cash:

• Savings account (high yield)
• Government backed securities maturing within 3 to 12 months (GICs, T-Bills or equivalent)
• Money market instruments which are available to consumers at the bank (Certificates of Deposit, money market funds)
• Fixed or guaranteed annuities (from insurance companies)

How Do I Start Building My Emergency Cash Reserve?

If you already have a cash reserve, that's great! Keep up the good work and make sure to review and adjust as necessary.

If you are ready to start one, begin by assessing your current situation. Here is a list of questions to ask yourself first:

• Do you have any debt or other financial obligations?
• Do you have anyone you can depend on, such a family member or spouse?
• What are your personal or career goals right now? Are you currently or will you be attending college or getting an accreditation?
• Are you able to cover your basic living expenses with your current income?

As general advice, start small and build upwards. It all starts from budgeting and setting savings goals. Aim to build up enough to cover 3 months worth of your basic living expenses, then re-evaluate to see if you can build it up to 4 months, then 5 months and so on.

If you have credit card debt or other high interest debt, focus on paying those off first. Out of control credit card debt is an emergency! This doesn't mean you must pay off all debts before you start building your emergency fund. Manageable student loans with fixed payments would be an example of debt you might keep around while building your emergency cash reserve. Just make sure to also factor in your regular loan payments.

With that said, having an emergency can be seen as a luxury by many. It is important to know there are many things that can take priority over it. It is often beneficial (especially for someone young) to focus on increasing income potential as opposed to hoarding cash.