This is a topic that’s been covered by every financial blog, podcast, book, or show, but we’ve got to cover it here as part of the basics because a proper emergency fund is a basic necessity to financial well-being and financial health and I refuse to give it short shrift just because it’s a readily-covered topic.
The traditional advice has been to have a 3-month to 6-month emergency/rainy day fund. That 3-months to 6-months doesn’t mean you have to have enough in your emergency fund to replace your income, it only means you need to have enough to cover only your expenses for 3 to 6 months. For example, if you make a household income $80,000 a year, 6 months of income would be $40,000. However, if you’re smart with your money and live below your means, your monthly expenses are likely less than your monthly income. It might be the case that $20,000 would be sufficient to cover 6 months of living expenses.
Why 3 to 6 months, however? Where did that number come from? If more is better, why not go for a full year of expenses? Why not two years? That’s tough to answer and there might be possible reasons for going beyond 6 months. For some conservative people or for those who believe there are rainy days ahead, a full year of living expenses might be reasonable. However, the larger your emergency fun, the more money that is sitting outside of the markets and earning very little interest. There is an inherent trade-off between the security that comes with an emergency fund and the growth that can potentially occur from having funds invested in the markets (be they equities markets, bond markets, real estate, or other investments) over the long-term. Be mindful of that trade-off when you are choosing the size of your emergency fund.
An important principle in creating your emergency or rainy day fund is conservatism. We want to make sure that we err on the side of caution: it’s better to have too much than too little. Additionally, having a conservative approach will make us keep our emergency or rainy day fund in a very safe place, namely a simple saving or money market account. An emergency fund isn’t an investment, it’s insurance for all of your other investments, protecting them from potential liquidation should an emergency occur during some sort of economic downturn.