The emergency fund
Your emergency fund is three to six months of expenses in an account you can reach at any time. It's not meant to grow. It makes sure you can stick with your investments through bad times.
Learning objective: After this lesson you can work out how big your own emergency fund should be.
Your emergency fund is money that sits around being boring, and that's fine. It's for the broken washing machine, the car repair, the dentist's bill, and for the case where your job disappears.
The rule of thumb
The usual rule of thumb is three to six months of expenses. It's about what you spend, not what you earn. If Jonas needs €1,800 a month to live, that's €5,400 to €10,800.
What depends on your life
How much you need depends on your life. Secure job, no children, cheap flat: closer to three months. Self employed, irregular income, family, old car: closer to six or more.
Where to keep the money
Where the money sits matters. Ideally in an instant access savings account you can get at in a day or two. Not in stocks, not in crypto and not locked away in a fixed term deposit for years. That inflation slowly eats into it is the price for having it there when you need it. You'll be glad to pay that price, at the latest when the first emergency comes.
You can think of the emergency fund as insurance whose premium is the return you give up. If €10,000 sits in savings instead of a broad stock portfolio that might earn about four percentage points more on average, that costs you roughly €400 a year on paper. Set against that is the damage of having to sell during a slump: such declines have quickly reached 20 to 50 percent in the past, and many people never get back in afterwards.
Three kinds of surprises
Instead of one blanket number, it helps to think of three kinds of surprises. Small ones, a few hundred euros, happen often and come out of your normal monthly budget. Medium ones, such as a car repair worth one to three months of expenses, come every few years. Large ones, above all losing your income, set the upper limit. How big that needs to be depends on how well you're insured and how quickly you'd find work again.
Why not an ETF
Why not an ETF? You can sell shares on any trading day, but you don't know what they'll be worth at the moment you need the money. And emergencies such as losing your job often come just when the stock market is doing badly too. Money you can get, but not in the amount you expected, doesn't help much in an emergency.
Summary
- Three to six months of expenses, not of income.
- In a savings account, not in the market.
- Losing some purchasing power is the price of having it there.
Did you get it?
Is your emergency fund based on your income or your expenses?
On your expenses. What counts is how long you can live without new income.
Why isn't a stock ETF a good emergency fund?
Because you don't know what it will be worth when you need the money, and emergencies often coincide with bad times in the market.
What does the emergency fund cost you?
The return you miss out on. In exchange you are less likely to have to sell at the wrong moment.
What others often ask about this
How big should my emergency fund be before I invest?
Three to six months of expenses is common. If your income is uncertain, you're self employed or you have children, go for more. It's about expenses, not income.
Can my emergency fund sit in a savings account?
Yes, an instant access savings account suits it well. The money has to be available at any time and mustn't fluctuate. Stocks or ETFs don't meet that.
Check your understanding
Your task
Take your monthly spending from the household budget lesson and calculate the amount for three and for six months. Based on your situation, meaning job, family, and car, pick one of the two figures and justify it in one sentence. Then enter the numbers in the emergency fund calculator and check how long you could get by without income.
Related
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