Having an emergency fund is important. No rational person would ever say an emergency fund is unimportant. Rationally, we know that bad things happen sometimes and we might need to have more liquidity at hand for such situations.
Whatever our persuasion might be in our journey as an investor, we cannot deny that cashflow is important. There could be times when cashflow is negatively affected and slows to a trickle or it could even dry up. That is when an emergency fund is drawn upon.
If our cashflow is a like a stream of water, an emergency fund is like a water tank that will dispense life giving water in the event of a drought.
The question of how big an emergency fund is enough is more difficult to answer because there isn't any one size fits all amount, obviously. Then, is there any guideline which AK could offer? Well, I could talk to myself, I suppose. Remember, however, AK is just sharing what he has done in his life. He is not a trained financial adviser.
Whether an individual's emergency fund is sufficient depends very much on his lifestyle, the number of dependents he has and how old he is.
We could have a simple lifestyle or a lavish lifestyle or somewhere in between. Of course, what is considered simple or lavish would differ from person to person. No matter what our definition, we will have certain expenses which are fixed or routine and some which are discretionary.
Fixed expenses are mortgages, Telco bills, loan repayments, insurance premiums etc.
Discretionary expenses are holidays, birthday parties, visits to restaurants etc.
Of course, there is some room for debate as to what is fixed and what is discretionary. However, I will say that fixed or routine expenses are those that cannot be eliminated as easily as discretionary expenses.
Number of dependents
For those of us who are still single, some of us might have to take care of elderly parents or young siblings. For those of us who are married, some might have children who still need to be cared for. Our dependents will have routine expenses (and discretionary expenses) too.
As we grow older, it is harder to find employment if we should be retrenched. If we manage to find re-employment, we might have to take a pay cut. Well, I am just taking my own advice to be pragmatic and not be overly optimistic or pessimistic. So, I think a bigger emergency fund as we grow older, all else remaining equal, is sensible.
So, bearing the above points in mind, is there a formula we can use to arrive at an amount that we should have in our emergency fund? Forgive me that I do not know how to express this in a neat equation. I offer you a neat paragraph:
If we take all our monthly routine expenses (our own + our dependents') into account, we will know what is the minimum amount of money we must have each month in order to maintain our current lifestyle. If we are in our 20s, multiply this amount by 6 to determine the size of the emergency fund required. If we are in our 30s, multiply by 12x. If we are in our 40s or older, multiply by 24x.
Someone once denounced me for being fake when I said I maintained an emergency fund enough to cover 24 months' of routine expenses. He didn't believe that I still needed an emergency fund because my passive income stream was strong enough to replace my earned income. Do you feel the same way?
If we remember my earlier analogy that our cashflow is like a stream and that our emergency fund is like a water tank, we will understand why I think an emergency fund is a must even if we should have a passive income stream.
So, how much should you have in your emergency fund? I hope this blog post has given you an idea.
1. Why a meaningful emergency fund is important?
2. Emergency fund: How much is enough?