How Much Should I Set Aside Towards My 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 flooding damage before you can go deal with the source of the issue. Having an emergency cash reserve works in the same way as a bucket would to contain the water from the leak.

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

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

Although it is not easy to plan for unexpected events, most people wish they had whenever something of the such happens.

Some of the most common situations where you would be relieved to have that emergency cash reserve include job loss, medical bills, car repairs and property damage such as flooding where you may need temporary accommodations.

Having enough money to cover your short term needs gives you the peace of mind that at least you will be OK financially. 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 money to survive for the rest of my life". And although that may be true, that does not mean they don't need quick access to their money. The access to your money is just as important as how much you have in your emergency cash reserve.

The more wealth you have, the especially more important it is to have quick access to your money. If you have a bigger home and bigger pipes, you will need a bigger bucket in order to contain all that water when it bursts.

Let's say you own a dozen rental properties worth millions of dollars that you have to maintain. There will be a much bigger problem on your hands if your cash flow comes to a halt, compared to someone who is used to living on a much lower salary. What good is it to have all your wealth locked up in illiquid assets when you cannot deal with the immediate issues at hand?

How Much Should I Have In My Emergency Cash Reserve?

Experts say that your emergency cash reserve should be able cover between 3 months to 12 months worth of your basic living expenses in case of an unforeseen event such as job loss or medical bills. This is not a universal rule, but only a 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 job or one that has seasonal worth, being able to cover only 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 yielding liquid assets. Which also means you are not investing your money optimally in other asset classes that generate a higher return.

if the turnover period in your industry very short, having 2 years of your income in your reserve would be overkill. A much better decision over the long run would be investing that into something like the stock market.

One key piece of advice to take in regarding how much to put in your emergency cash reserve, is to plan in terms of percentages rather than an absolute dollar amount.

What Investments Should I Keep In My Emergency Cash Reserve?

We know that your emergency cash reserve should be kept fairly liquid where a signficant 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 help in cash or only in your checking or savings accounts. The longer the time period that your reserve can cover, the more you should consider portioning it out.

Assume you are holding three months worth of expenses in your basic savings account. You can then hold a portion of your emergency funds in (principal protected) money market instruments that can be withdrawn between 3 to 6 months (or 6 to 12 months) as necessary.

Here is a list of financial instruments which you should consider in addition to just cash or checking account:

• 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 Build My Emergency Cash Reserve?

If you already have a cash reserve, that's great! Keep at the good work and revise as necessary.

If you don't yet have an emergency cash reserve, how you start really depends on your current situations. 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 (especially to live with) such as parents or a family member?
• What are your personal or career goals right now? Such as if you are planning on or currently attending college or university?
• Are you able to cover your basic living expenses with your current income?

As a general piece of advice, it would say start small and build up your reserve. It all starts from budgeting and being able to save a portion of your income. Once you built up your reserve 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 until you are satisfied.

Alternatively, if you have credit card debt or other high interest debts, focus on paying those off first before building up your reserve. Out of control credit card debt is an emergency! But this doesn't also mean you should pay off every piece of debt (including manageable student debt) before you start building your emergency fund.

With that said, I understand that having an emergency fund to even cover one month of expenses can be seen as a luxury for many. It is important to know there are many things that take priority over it. Many times the better advice would be to focus on trying to increase your income rather than managing your liquidity.