An Emergency Fund is Like an Insurance Policy
We all know (or should know) that having an emergency fund is crucial to successful financial planning. Having a rainy day fund is one of the first things people should do when controlling their finances.
An emergency fund, although part of your overall financial picture and financial portfolio, should not be considered a part of your investments. Although you should search for a good rate of return on your emergency fund, safety must be your primary focus when choosing a place to put it. It is best to think of an emergency fund as a type of insurance policy. Thinking of your emergency savings as insurance will allow you to get a better or better-rounded grasp of your emergency fund’s place in your overall financial portfolio.
When you purchase insurance, you are paying a premium (usually on a monthly basis) for the assurance that a certain risk will be covered should the underlying event occur (or not occur in some cases). For example, when you purchase car insurance, you pay a monthly premium, and in return, you and your car are insured. If something happens to you or your car while driving, the insurance company will cover the tab less your deductible. We purchase insurance to insure against risks that we cannot bear ourselves or risks, should their underlying event occur, cause financial disaster for us. Insurance, for most people, comes out to a net loss. Over your lifetime, you will pay more for the insurance you purchase than you will receive as having been insured. We still purchase insurance, however, and the reason we purchase it is not that it is a profitable venture (it isn’t in most cases), but because we want to be protected from catastrophic events so that we can focus on the rest of our life and continue building wealth.
Your emergency fund is like an insurance policy. Instead of paying monthly premiums, however, you give up potential return on your money by having it in a very safe financial vehicle (eg. a savings account). Instead of investing your money in stocks, real estate, or other ventures, you keep your emergency fund in a savings account, CD, or liquid cash. It is very likely that inflation will be slowly eating away at your emergency fund’s purchasing power, especially with today’s historically low-interest rates. You are giving up potential returns on your money and likely losing real value for the assurance that you will have a pile of cash sitting there should an emergency occur. This allows you to both focus on all other aspects of your life with an increased sense of security and ensures your investment portfolio (which should be invested in various ways to maximize long-term returns). If an emergency arises, you don’t have to liquidate your investments. Consistently having to liquidate investments will be disastrous for the long-term growth of your investment portfolio and could be catastrophic should you be forced to liquidate in the kind of deep financial downturn we witnessed in The Great Recession.
You will be well-served by understanding the real role that an emergency fund should play in your overall financial picture: that of an insurance policy where you accept lost returns and lost purchasing power for added security.