Why do you need emergency reserves?
A well-structured emergency reserve solves the question of what to make a living from if your income slips for something. If you have such a reserve, you can plan the next step more calmly. Another benefit is that there is no danger of everything that you have been building for many years immediately collapsing.
It sounds strange that right in the middle of a quarantine and a market downturn, I am writing about the need for an emergency reserve fund. After rain, however, comes the sunshine, followed again by clouds.
In the last 10 years, there has been a lot of news that the economy is booming, businesses are getting lots and lots of orders, wages are rising significantly, and the shopping cart is packed to the brink of collapse on payday. It was then hard to imagine what happened in the 2008 mortgage crisis. Thus, not much was said about the need for an emergency reserve fund.
After the 2008 crisis, there was more talk of redundancies, cuts and austerity. Back then, as in the current situation, many businesses have found themselves in a difficult situation and many people have lost their jobs.
So it’s right that I’m talking about the umbrella feeling the breeze of the coming sunshine. It’s still very easy to move on so that a surely-coming next rain won’t wash everything away.
Hence, I thought I was looking at an old topic: the emergency reserve.
So the topic is emergency funds / reserves / anything you want to call:
1. There is a well-known rule for financial planners that says: Before you open a business or invest, you need to have emergency reserves. If you have a business, then as the business and you as a private person need to own it separately.
2. This emergency reserve must cover the cost of living for a minimum of 3-6 months, but up to 1 year for a business.
3. This money must be either in cash, or in a bank account, but in any case easily accessible or easy to monetize.
4. And can only be used in case of emergency (eg unemployment, drop in orders, late payment).
What is an emergency reserve?
An account to which you place an amount that you only use in an emergency (e.g., job loss, illness, or any unexpected major expense). The purpose of this amount is to increase your financial security by providing a financial safety net.
This can ultimately be used for vital expenditures instead of buying on a high-interest credit card or having the bank take your house. (No, the 180 cm diameter plasma TV is not vital. )
Why do you need emergency reserves?
The basic reasons are:
1. There is a time difference between seeing money from your work and investment and your overdue payment deadline (i.e. your liquidity needs). This means you need money right away, while your investment decisions are (usually) designed for a longer-term return. And selling a long-term asset for short-term cash can be painful – especially if you sell at the wrong time. Provided you can sell it at all.
2. If you have extra money, it feels good. And it’s safe.
3. And finally: life. Because according to Murphy’s law, what can go wrong goes wrong. If your insurance doesn’t necessarily cover that particular loss, you can either rely on some kind of reserve or be in a hurry, which is fixed to be a very expensive pastime.
Thus, it seems obvious that you need an emergency reserve, which should be available in cash, but at least quickly.
Where do you keep your emergency reserve?
As a general rule, for those who don’t have savings, the biggest gain you can get is your savings habit. This is also important as a company, if you turn everything back, you may have a higher return, but you are only on one foot.
And if you’re a beginner trying to learn the habit of saving, you really need to save cash. Just because you already know it, it can’t go wrong.
But as time goes on, I think that will change.
For the sake of example, let’s take John, who has now decided to build up a private emergency reserve. John agreed to share his example in accordance with the GDPR
- Let’s say John earns a net 500,000 forints a month and spends 250,000 forints monthly. He has a saving potential of 250,000 forints here – but because he doesn’t necessarily live alone, he spends the extra for fun and living large.
- Then the careful neighbor / uncle / financial advisor who looks at him seriously and says “You should spend less because it won’t be good that way: here’s a standing transfer order, sign it.” (Anyway a financial advisor doesn’t say it that way. What does a careful financial advisor say? Contact us and find out )
- So he starts transferring 50,000 forints every month to a bank account opened for this purpose, say a savings account. That’s how he can have fun and still able to save.
- Now, in accordance with the emergency reserve rule (ie to cover the 6-month expenditure), John has to keep a cash reserve of 6 * 250,000 HUF = 1,500,000 HUF. This means that by transferring 50,000 forints a month to a savings account, it takes 2.5 years to complete.
- It significantly improves his savings situation every month. In the second month, the second 50,000 forints increase his savings by 100% (100,000 is exactly the double of 50, so it increased by 100%). In the third month by another 50% and so on.
- The stock market can produce an average of 8-10% annually. The 600,000 HUF collected by the end of the 1st year could be extracted for about 1 month instead of John. If John kept the entire required reserve in shares, his assets would increase by an average of 150,000 forints per year, ie a full quarter would be payed without him having to deal with it.
Do you really need to store the emergency reserves in stocks?
It sounds good that the market is adding to your wealth, but in case of building an emergency reserve I would warn everyone not to invest it all in stocks.
As you can see, I wrote that it produces 8-10% on average. This means that there will be a year when +50, and accordingly there will be a year when -40. Since trouble never goes alone, you typically get into such trouble that you have to reach for the emergency reserve when the market also falls.
The image below shows the S&P 500 index. It shows the performance of stocks in America’s 500 largest companies. You would get a similar result in the world with other equity-based investments, so now it’s enough to look at this one.
You can see that you do well with it many times, but it slips into a few years when you can get a minus with it.
Are you doing well to keep your emergency reserve in cash?
Before I answer that, let me ask you, do we all agree that John’s new situation is very different from where he was two years earlier?
It started from the fact that he had no money set aside, let alone no six months ’cost of living in cash. And at this point, I begin to question the traditional wisdom that all emergency reserves should be kept in cash.
There are some questions about “cash”.
You must have heard of inflation. In the picture you can see the inflation recorded by the IMF, the reality in your case may be slightly different, but it is definitely similar.
If you keep your emergency reserve entirely in cash, you will have to work harder and harder to keep the value of the buyer.
Keep some of them in cash and invest the rest in a “crisis-proof” way. This way, you may be working your money at a lower rate, but it will remain value-worthy.
If you are interested in this more, please contact us.
Then diversification, i.e. distribution to different places, can be used excellently as a method.
In the meantime, you can read some helpful thoughts on diversification as to when your emergency reserve is in a good place compared to others.
Concluding remarks on the emergency reserve
If you don’t have an emergency reserve, put it together in cash.
If you already have accumulated emergency reserves, invest part of the amount in a crisis-proof manner.
Here you can now handle flexibly the reserve.
All this means is no longer so necessary to keep your emergency reserve fund completely liquid.
This is when you can start clearing up the amount of cash that comes from saving, aligning your short-to-medium-term goals.
- How have you dealt with the issue of emergency stocks so far? What are you changing now?
- When do you think you’re better about the contingency reserve: if you keep all or part of that amount of cash in cash?
- What of the above was different for you than you thought so far?
If you need help, find a way to us in the contact menu.