A favorite topic of controversy when it comes to personal finance is exactly how large an emergency fund should be. Some say 4 months, other say 6 months, and yet others say 12 months.

An emergency fund is intended to provide some slack in the highly leveraged game of finance that most people are playing these days. Here we are talking both money based leverage, that is, lending money which comes at the cost of a default risk if such payments are not made, and skill based leverage, that is, being good at only a few things, which comes at the cost of job-risk as the job is needed to pay for everything else in life.

The size of the emergency fund thus depends exactly on how risky your personal system is. For instance, if you “need” $100k/year to live, and you live in an area, where $100k jobs are scarce, obviously your emergency fund must be larger than if the jobs you needed are less scarce. Furthermore, if your competence for your desired income lies in a narrow range, the emergency fund must also be large. Conversely, if your needs are less and you are widely competent and thus able to easily pick up a new job, your emergency fund can be so much smaller.

Second, there is the question of “needs” vs “wants”. It stands to reason that in an emergency, many people can cut a lot of superfluous fluff out of their lives such as … I’m not even gonna start on that one 🙂 In the strictest sense, the emergency fund should thus only cover the expenses for the months (as given above) for things that can not be eliminated and cancelled.

Now, things change substantially if you are not a member of the dual income dual expense leveraged consumer middle class, yeah, that is surely a group with a long name.

First, if you save more than 50% and you have more than one income in the “family”, or more accurately, if you can live on the smallest income while saving the other income, you are doubly covered and possibly of no need of an emergency fund, since the likelihood of both persons losing their job at the same time is quite small, no?

Even better, if you save more than 50% and you have more than one income personally, and you can live on the smaller of those, you are even more safe. That is job-diversification. Did you ever wonder why people almost universally recommends putting all your eggs in one basket when it comes to your employment while recommending exactly the opposite when it comes to investments?

Speaking of which, if you save a lot of money in real accounts, that is, not retirement accounts, you might as well invest it. Of course this depends on how “emergency”-prone you are. Some people’s lives seem to resemble ongoing train wrecks, whereas other people tend to curse their insurance payments as sunk money. The former should keep an all cash position, but the latter could move into investments and simply monitor whether those investments meet their minimum holdings. Suppose, for instance, that you have a $5000 emergency fund. Now invest $6000 in an ETF and put a stop-loss order in so it won’t go below $5000. If you need the money, simply liquidate. If the market drops, you still have your money.

Once you have saved substantially more than this, an emergency fund becomes superfluous as it makes little sense to keep cash for it’s own sake. Rather than keeping money that does nothing, just keep it invested. If you have an emergency, consider it an opportunity to liquidate your worst situation. Otherwise, adjust your cash position according to your investment strategy rather than your job and accident prospects and general lifestyle.

That’s my opinion on emergency funds. Like anything else, rather than faithfully replicating some piece of some guru preacher authority, understand what the real purpose is, and then implement your own solution.

Originally posted 2009-06-25 23:24:28.