Last Updated on July 18, 2020 by Dividend Power

If you are an investor you need an emergency fund or rainy day fund. In fact most adults probably need an emergency fund. There are just too many unexpected events that occur in life. An emergency fund can help you deal with these events whether they are higher expenses or lower income.

Emergency Fund

As an investor you need to take care of the basics. My emphasis has been on dividend growth stocks. However, I was not always a dividend growth investor. In fact, before I had enough money to buy my first stock, I had to take care of the basics. One can probably recall from college, Maslow’s hierarchy of needs. At the very bottom two levels of the pyramid one needs to satisfy two basic needs that are physiological needs and safety needs. These include food, water, warmth and rest, and security and safety. I put an emergency fund in these two categories. It is a basic need.

Maslow’s Hierarchy of Needs

Why You Need An Emergency Savings Fund?

Hence, first and foremost I needed to take care of my investing basics, which in my opinion was creating an emergency fund. This may not seem relevant, but it allows one to handle financial surprises that is a regular part of life. This is important. Unexpected financial surprises can be expensive, stressful, and limit your ability to build wealth. What are these unexpected events? They can largely be categorized into unexpected expenses or unexpected loss of income.

Unexpected expenses can include medical or dental emergencies, unplanned home repairs, unplanned car troubles, recession, and others. The more worrisome of the two categories is unexpected loss of income due to a job loss. One only needs to look at the news to realize that unexpected financial surprises are largely beyond ones control. Ultimately, an emergency fund can help deal with these surprises and help cushion the blow.

Americans Don’t Save Enough

As a rule, Americans generally do not have enough money set aside to deal with unexpected events. Roughly 19% of people in the U.S. spent more than their income in 2018. This has led to a situation where many people simply do not have enough money to cover emergencies.

For instance, 23% of all Americans have overdue medical bills. Medical bills are usually expenses beyond monthly expenses and make it harder to make ends meet each month. But having an emergency fund in place could help one deal with medical or dental emergencies. The other options are undesirable in my opinion. For example, one could take a loan or hardship withdrawal from a retirement account, but this limits your ability to build wealth. Retirement funds should be allowed to compound over long periods of time to build wealth. Alternatively, you could borrow money, but this adds to debt that must be paid back.

Not having an emergency fund is a fairly large problem for most people in the U.S. In 2018, 49% of Americans had a rainy day fund but 46% did not have one. These numbers have improved over the past decade. In 2009 only 35% of Americans had a rainy day fund. So, the data in 2018 shows a large improvement over the past decade. I attribute this to painful lessons learned during the Great Recession combined with the recently robust economy.

Low-Risk and Liquid Is Key

Saving for a decent size emergency fund can be hard but it is not impossible. One needs to plan for it and put aside money each month in a separate account to build the fund over time. A separate bank savings account or money market account keeps temptation low for using the fund on a non-emergency. Note that a money market can lose value since they are not federally insured. The best place according to FINRA is a low-risk and liquid account that is easily accessible. An emergency fund can help handle those unexpected financial surprises.

How Much Do You Need In An Emergency Fund?

How much is enough for an emergency fund? I think that three months’ worth of expenses is a minimum and obviously six months is better. But for some that may not be enough. If you work in an industry where layoffs or work stoppages are common than one needs to factor that into your calculations. If your income is non-steady, such as occurs for actors, artists, or real estate agents, then one may need to consider an even more robust emergency fund of 12 months. Retirees who rely in stocks and mutual funds as part of their income may also need a larger emergency fund. One never knows when dividends will be cut or suspended due to poor market performance or a ‘Black Swan’ type event, e.g. coronavirus pandemic. Families that have a single income may also need a larger emergency fund. In any case, having some sort of emergency fund is better than nothing at all.

How Do You Save for An Emergency Fund?

How do you determine the amount you need for the emergency fund? One possible method is to total up your monthly essential expenses such as mortgage or rent, food, health insurance, car expenses, personal expenses, student loan payment, etc. and multiply by three, six or 12. You can take out non-essential expenses that one can do without for the duration of the emergency like eating out, vacations, movies, etc. These seem like necessities to some but they are largely consumer discretionary. One needs to set a realistic goal. Having a goal can help you stay motivated in creating your emergency fund.

Even a small amount of savings per week or month can add up quickly. For instance, if you save $50 per paycheck then you are saving about $1,300 per year assuming a bi-weekly paycheck and 26 paychecks per year ($50 x $26 = $1,300). This does not seem like much but double it to $100 per paycheck then the savings are $2,600 per year. So, arguably in one year you could have about 1 – 2 months of expenses in an emergency fund depending on your actual expenses. If are able to save even more per paycheck the dollar value goes up even more quickly.

Another strategy is to direct a raise toward the emergency fund. If you are earning $50,000 per year. A 3% raise will give you an additional $1,500 before deductions and taxes. Assuming that taxes and deductions equal 33% then you still have $1,000 left over to save for an emergency fund.

A third possible strategy is to use tax refunds to jump start or rapidly build an emergency fund. In 2019, reportedly 72% of all Americans received a tax refund from the federal government. The average refund was $2,860 in 2019. So, this would go a long way to building an emergency fund. Hypothetically, if one receives the average refund combined with saving $50 per paycheck, then the emergency fund is fairly decent size at $4,160. Save for two years and then the emergency fund is double that, which is pretty good.

You get the idea. One pretty much needs a system that you can stick to religiously for an extended duration. Once the emergency fund is sufficiently large enough for your personal situation the monthly savings can be used for other purposes such as investing to build wealth.

Final Thoughts

I wrote the original article in mid-February before the coronavirus started to spread around the world and shutdown much of the global economy. I updated the article on April 16, 2020. In hindsight, the article was eerily prescient. In any case, recent events have reinforced the need for an emergency fund for small investors. In my opinion, I think the three steps for saving would be to (1) set a goal, (2) create a system, and then (3) save.

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