Do you need an Emergency Fund?

If you look up emergency fund's online various financial influencers and institutions on the whole recommend having anywhere from 3 to 12 months worth of living expenses sat in a savings account earning minimal interest.

Living expenses are considered to be your non-discretionary (essential) spending such as rent, bills, food and transportation.

Funnily enough there are a number of banks that recommend doing this who make their money from lending your money out to other customers at much higher rates than the interest you earn in your own bank account.

The aim of having an emergency fund is to cover financial emergencies such as:

- Losing your job

- Car troubles

- Unexpected home repairs

- Medical emergency

Essentially any situation that requires money which has not been prepared for in advance.

If your living expenses are £2,000 a month and you wanted a 6 month emergency fund then you would have to save up £12,000.

If you do put money aside for an emergency then there are two options worth considering:

1. Easy access savings account

2. Money invested in a global index fund

You can find the best easy access savings account on the Money Saving Expert's website.

For me personally I cannot stand to have cash just sat in a savings account earning minimal interest where the likelihood of me requiring that money is low. This is all about risk vs reward.

You might think that it is financially irresponsible to have any money that is to be used in the case of an emergency to be invested in a global stock market index fund, as its price will fluctuate over time.

I completely understand that there is a risk with emergency money being invested in an index fund, because if the market dips and you require your emergency fund money, then you will be selling at a loss.

If you have your emergency fund money invested in a global index fund and a financial emergency arises, you have two options.

1. Sell of some of your investments

2. Go into debt

However, you could go for a long time never needing to dip into your emergency fund or you might not ever need to dip into it if your monthly pay/credit cards can cover an emergency in the short term.

If you did have all of your emergency money in a stock market index fund and an emergency did arise where you needed cash at the same time as the market crashing, you could mitigate this risk through using credit cards.

Whatever you decide to do is going to come down to what you can sleep best with at night. This might be putting your emergency money in an easy access savings account. However, it is guaranteed you will get a rubbish rate of return.

It is important to note that with money invested in a global index fund on Vanguard (the only platform you should be using), it takes up to five working days for money to land in your account after placing a sell order.

Benefits of Investing your Emergency Fund in the Stock Market

1. Your money is put to work

If you had £12,000 invested in the stock market and it returned its historical rate of return, which is roughly 8% this could earn you £960 a year.

If on the other hand you had £12,000 sat in a savings account at 1%, you would earn a measly £120 a year which is £840 less than the stock market returns per year (8x less returns).

2. Time in the market beats timing the market

For you to save up an emergency pot of money which could be as much as 12 months of your living expenses or more, this could take you years. In that time the stock market will have more than likely risen and you have lost out on these gains as a result.

On average the stock market rises 75% of the time and falls 25% of the time.

Read my post on why timing the market is a waste of time by clicking here.

How to Mitigate the Risk of an Emergency Fund Invested in Stocks

1. Credit Cards

If you don't have any cash available a credit card could be used to cover a financial emergency.

Credit cards should ONLY be used if you will be able to pay the balance off in full by its due date which will likely be the following month, otherwise you will begin to accrue stupidly high interest.

Using a credit card could be used to fund an emergency if you could subsequently pay it off using your next pay check. Your monthly pay alone still might not be enough to cover your financial emergency and at this point you will be required to sell off some of your investment.

2. Sell off some of your investments (dollar cost averaging)

If you are put in the position where you will need to sell off some of your investments to fund an emergency and the market dips you may not have lost as much as you think.

Morningstar provided some analysis looking at past stock market crashes, in which the US stock market lost 58% of its value from the peak of the dot-com bubble (August 2000) to the floor of the 2008 global financial crisis (hit rock bottom in February 2009). The Covid-19 pandemic caused the US stock market to decline by 18% from January 2020 to March 2020.

If you had to sell off some of your investments during these stock markets drops then you will likely be losing money, but probably not as much as these headline figures. But why is this? If you are regularly contributing money to an emergency fund then you are buying into the stock market at fluctuating prices. The crashes mentioned above are tracing through the highest point of the US stock market to the very lowest point.

So unless by some great misfortune you invested your entire emergency fund on the day of the highest point in the market and then required this money in an emergency, and subsequently sold it at the very lowest point in the market, you will not be realising losses as great as those that are mentioned above.

This is the dollar cost averaging effect, where continually investing a regular amount into the stock market at various prices means that if you do need to sell when the stock market falls, your loss won't be as much as the gap between the peak and trough.

For example, let's say you put £100 each month into your global index fund emergency use Covid-19 example

Morningstar analysis click here

Global Index Fund

As the money invested in a global index fund is not as easily accessible as an easy access savings account

Pros

- Good returns

Cons

- If you need money for an emergency when the market is down you will be selling at a loss

- Takes up to 5 working days for the money to hit your account

What Should you do?

You need to understand what you are comfortable with? You also need to deeply consider your financial situation. How secure is your job? Is anyone financially dependant on you?

You could even consider doing a 50/50 split between your emergency fund sitting as cash and invested in a global index fund.

If your job is very secure, even if you had to take money out of the stock market at a loss to fund an emergency, you could then buy back into the market while it's likely still down with your next pay slip (mitigating some of the loss realised).

In addition, when contributing to an emergency fund invested in a global index fund you are more than likely going to contribute a regular amount monthly. Therefore, you will be dollar cost averaging (investing a regular amount regardless of the price).

As a result, if an emergency were to arise in a year with the markets plummeting 30%, anything you sell off hasn't necessarily lost exactly 30% as the price you have been buying at in the past would have been fluctuating.