Why You Need an Emergency Fund: The Most Complete Explanation Ever
Does anyone in the financial media or the financial press even address the question of why we need an emergency or rainy day fund? I feel that the idea of having an emergency fund is so deeply ingrained in the personal finance world that no one in personal finance discusses why you actually need an emergency fund. I don’t think that’s wise. If we are going to save up 3-months to 6-months in living expenses (a serious pile of cash), we better have a good reason for it. Otherwise, why bother with it? We could either spend that money on things we enjoy, give it away to someone in need, or invest it in the markets where the money has a chance of obtaining a return and growing. Why would I just have a pile of cash sitting around earning abysmally low rates or return if there isn’t a solid foundation to it?
First, let’s define a term – Stochastic
Something is said to be stochastic in nature when it is randomly determined or when it’s probability distribution cannot be precisely predicted.
Stochastic is sort of the same as random. So we can say, “this is a stochastic process” or “these events are stochastic.”
Here are a few examples of stochastic processes or things that have stochastic components to them:
- Weather events
- Stock movements
- Certain biological processes such as gene expression
- Parts/components failure in machines and structures
- Social events such as riot, aspects of elections, and the viral nature of content
The term stochastic is heavily used in mathematics, but we don’t need to give the term any more treatment than we have already. I didn’t use the word “random” because I wanted to really bring home the fact that the physical and life sciences, mathematics, and even the social sciences recognize the fact that the world is random and unpredictable in many ways. For many things that have a material effect on our lives, it might be possible to understand the general distribution of things (eg. what will happen on average) but it is not possible to understand what will happen next.
The World is Stochastic in Nature
As stated above, the world is stochastic in many ways. The world is filled with randomness and random processes and occurrences. There’s no way to tell exactly when your car will break down, when a major weather event will require a window replacement, or when your body will have some sort of medical emergency. There’s not a way to predict when you’ll get into a car accident, trip while walking off a curb, or when the economy will fall into a recession and you will lose your job. Hopefully, none of the above ever happens to any of us, but there’s no guarantee. And so, we must be prepared as best as we can.
One way we can be prepared for possible emergencies is to be financially prepared. We can be physically prepared, mentally prepared, emotionally prepared, and spiritually prepared, but we must also strive to be financially prepared to weather life’s inevitable blows to our peace and tranquility.
Now that we understand that the world is random, we can see that this randomness might cause financial emergencies – things we weren’t anticipating that require the use of money.
How can we react to such financial emergencies? There are 4 main ways you can react to a financial emergency:
- Sell Your Investments (assuming you have some)
- Cash Flow Through the Emergency (assuming your income is high enough)
- Go Into Debt
- Use Your Emergency Fund
4 Ways to Handle an Emergency
1. Sell Your Investments
One way to handle a financial emergency is to sell your investments (if you have them,). If you’re invested in the stock market, for example, you can liquidate enough shares to take care of the financial emergency. That’s easy, right? Wrong.
If your emergency occurs after at the end of a long bull run, then that selling your investments to pay for your financial emergency could possibly be a reasonable idea. But what if your financial emergency occurs during a recession? Isn’t it more likely that a financial emergency such as losing your job will occur during a downtrend in the stock market. What if there is no recession or downtrend, but your particular portfolio is down? Selling your shares to cover the financial emergency will be very unpleasant and it will further compound the already bad situation. You’ll basically be locking in the losses and losing an opportunity for a possible recovery. You want to have the opportunity to ride out the downtrend should you so desire.
The example with stocks can be extended to investments in commodities, real estate, bonds, and derivatives. You don’t want to have to sell when things are down. You want the flexibility to be able to stay invested and ride things out.
2. Cash Flow Through the Emergency
Not everyone has investments and even if they do, they might not have enough invested to cover a financial emergency. So, if you can’t sell investments to pay for it, maybe you can just cash flow through the financial emergency – maybe you can just pay for things with the income you have coming in every month. But what if your emergency is such that your ability to earn an income is diminished or eliminated for a period of time? What if you just don’t make enough to cash flow through your financial emergency?
It’s pretty risky to rely on your ability to earn your way through an emergency. Say you need a car repair that costs $500? You can cash flow through that relatively easily. But what if you have a medical emergency with a high deductible? That’s more difficult. What if you have a major repair that needs to be done to your house? That’s pretty difficult too.
3. Go Into Debt to Pay for the Emergency
If you have no investments to sell and you can’t cash flow through the financial emergency, you’ll probably have to go into debt to take care of things. That’s obviously a bad situation. You’re again compounding the bad stuff by going into debt.
But what if you can’t go into debt? What if you don’t have enough on your credit cards? What if you can’t get a loan? Now you’re totally stuck aren’t you? No money and no ability to obtain funds elsewhere will mean you’ll have to resort to asking your friends and family for assistance or for loans, a pretty unattractive proposition.
So, the above three options for dealing with a rainy day are obviously not optimal. There’s a fourth option: have a rainy day fund.
4. Use your Emergency Fund
It should be obvious by now that an emergency fund is the optimal way to deal with life’s financial emergencies. It’s better than having to sell your investments to deal with a financial emergency because the emergency fund acts as an insurance policy, protecting you from having to liquidate your investments. If you don’t have investments yet (keep reading Pennies and Pounds and you will soon), then the insurance policy allows you to move forward after a financial emergency without going into debt and without stress and anxiety. It allows you to take life’s financial blows and get right back up again instead of staying knocked down.
So, we see that random stuff happens and that the best way to protect yourself and your household is to have an emergency fund. An emergency fund will benefit you whether you have lots of investments or no investments at all.
But there’s one other reason to have an emergency fund in place…
Not Every Expense is Monthly
Most people think in terms of monthly income and monthly expenses. The more sophisticated or the more financially nerdy among us (myself included) might think about yearly expenses. But there are many expenses in life that are not monthly. Expenses can happen:
- Car registration
- Tax filing fees to your accountant
- Car maintenance
- Membership fees and dues
Every few years
- Major car repairs
- Home maintenance and repairs
Every 5-10 years
- Home repairs
- Car replacement
Only a few times in your life
- Children’s college tuition
- Children’s wedding
- Your own wedding
- Engagement ring
- Burying parents or other relatives
I hesitated to discuss these expenses in this piece because they aren’t proper emergencies in my opinion. Emergencies are surprises that are unforeseen, but the above expenses are not unforeseen – I just wrote about them and named off a bunch of possible expenses that are not monthly. We should plan for them because we can obviously anticipate them, unlike an actual emergency such as a car accident or an injury. So, why did I include them?
I included these expenses because of my awareness of human nature. Humans aren’t great at anticipating the future and planning ahead. I know that these expenses aren’t proper financial emergencies and I know that we should plan for them, but I also know that we’re humans and the reality is that most people will neglect to plan for them. That’s just human nature. Studies show that most people fail to even have a basic emergency fund, let alone save for far-off expenses. People have a tendency to focus on the here and now and to not pay attention to what is coming down the road. Therefore, I do believe that an emergency fund can act as a certain protection against our human nature, against our seeming inability to see too far ahead. It acts as a cushion not just against life, but also as a cushion against our own minds and our own selves. If, in a moment of rationality, we can understand this about ourselves (our poor ability to plan for such expenses) we might be able to set up a very strong foundation for our financial security.
An Emergency Fund Just Makes Sense
An emergency fund is important. It just makes good sense. An emergency fund is one of the simplest and most prudent financial moves you can make. Since antiquity, the wise have understood the importance of storing something away for a rainy day.
There is treasure to be desired and oil in the dwelling of the wise; but a foolish man spendeth it up. (Proverbs 21-20)
So, make sure you have a proper emergency fund in place and do the hard work needed to get one set up quickly. You already knew that you need a rainy day fund I’m sure, but now you know why with what is probably a much deep and much more sophisticated understanding than most people have.
P.S. Let’s get a bit philosophical – Do emergencies even exist?
I couldn’t help getting a bit deeper and philosophical here. Let’s think about this. We figured out that life and the world are random and that random and unpredictable (stochastic) stuff will happen. So, are there really any real financial emergencies? By definition, an emergency is something unpredictable. But, although we can’t exactly predict when something bad will happen because of the stochastic nature of things, we can definitely be sure that the world is random and that something might happen at any time. So, we should never be really surprised when we have a financial emergency became we should already know that it’s a possibility. Regardless, we still need to have a rainy day fund set aside. So maybe there aren’t really emergencies after all – maybe there are just those things that we know will happen and those things that could happen but shouldn’t surprise us if they do. What do you think about this? I’m interested in your opinion on this – comment below.