In the next 2 posts I will try to deepen the discourse of the emergency fund to be kept in case of unexpected events.
I decided to include this topic among the opinions, because everyone has their own view of the topic. In my own, I remain of the idea that we need to choose what makes us feel as calm as possible.
It depends on a single bias, mental accounting.
People have different risk profiles for different money accounts.
The fund should help you stay calm and not make any sudden moves with your investments.
I will immediately analyze the accumulation phase.
The Financial planner theory recommends 3-6 months worth of expenses in an emergency fund. You have to update the emergency fund according to your annual expenses.
Going forward I have to create a typical example with which to continue this post. You have to adapt and analyze all calculations for your case.
I assume €35,000 per year of earnings and a 40% saving rate.
So, this means that €21,000 are spent on living and €14,000 are invested.
If we assume 3-6 months of money for contingencies, we have an emergency fund of €5,250-10,500.
For simplicity, I’m assuming the 3-month scenario is already set up before you start investing.
Do you remember the efficient frontier?
Well then you have to imagine that the emergency fund will limit part of your returns.
If I had a 3% return after the first year of the previous case. You should calculate the €420 on €14,000 but on €19,250 (14,000+5,250).
Now the return is 2.18%.
Naturally the following year the weight of the fixed money will be less than the total and the following year even less and so on.
So is it better not to have the fund or to have it very small?
Yes and no.
The smaller it is, the less it affects the total return, but you are more exposed if you are fired.
I remain of the opinion that during the accumulation phase the fund shouldn’t be huge, as you are generally young and always have time to find another job and you can make sacrifices that you cannot do as an elderly person.
Furthermore, losses on the stock market should not affect our lives and market crashes can still be recovered.
in the next post we will see the retirement phase and what to invest the emergency fund in.