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Build an Emergency Fund to Protect Yourself During Unexpected Life Events

Purpose of this article: to define the emergency fund and help you put together a plan to increase yours. 

Bullet Point Summary

  • Building an emergency fund to cover 3-12 months of expenses will take time
  • Focus first on saving $1,000 as soon as possible
  • Commit to saving all windfall payments you receive like tax refunds or any year-end company bonuses
  • Over the long-term you will need to spend less to save more and look to make more income overall
  • Building a good budget that helps you cut back on spending will be key
  • Save any yearly raise received. 1% to 3% can add up quickly
  • Rinse and repeat until you hit your goal

Overview

Ask any financial planner and they will tell you that an emergency fund is a must. Some will suggest you save upwards of three months of expenses while others will tell you one full year.  In this article we discuss the ins and outs of the emergency fund and conclude by giving you strategies to boost your emergency funds.

What Are Emergency Funds For?

The ultimate point of the emergency fund is to set aside cash to cover your most basic needs during an unexpected life event. We all have differing wants and desires in life, but our basic biological requirements for survival are the same. When push comes to shove, we need air to breathe, food and drink, a place to lay our heads at night, and clothes to wear, as depicted in Maslow’s Hierarchy of Needs:

Maslow’s Hierarchy of Needs

Consequently, an emergency fund needs to be established to cover unexpected financial situations like the eviction from an apartment, loss of a job, medical bill,  or temporary disability to name a few.  In these situations, you’ll need immediate access to cash to cover your most basic expenses and needs while you get your financial situation back on track. 

Is There a Right Number? 

In a 2018 article, CNBC found that only 39% of Americans had enough savings to cover an $1,000 emergency. Defining the “right number” for an emergency fund is hard because financial emergencies by their very nature are unplanned and their lengths unknown. Instead, we suggest thinking through some of the larger types of unexpected life events that could cause you to dip into your emergency fund and planning specifically for those:

  • Loss of steady income from primary job – it takes roughly one month per $10,000 you make to find job per thebalancecareers.com. So a person making $50,000 a year would need at least five months of income saved up (roughly $21,000) to tidy themselves during their job hunt.
  • Major medical expense – the average emergency room visit can cost $1,200 to $2,200 without insurance. Other hospital costs like X-rays and surgical procedures can average over $3,900 with hospital stays costing over $15,000 without insurance. And these days it feels like there is no upper bound on medical bills even with insurance. 
  • Car repairs and maintenance – depending on the severity of repair, costs can range from $300 for a water pump replacement up to $3,000 for a transmission replacement.
  • Major household repairs – similar to car repairs the cost of household repairs will very with the severity of the repair. An new HVAC system can cost 3,800+ while a new roof can run into the tens of thousands.

Using these four large unplanned expense, we build the following table to give you suggested savings targets at differing levels of income: 

These savings targets are simply estimates and provide months of coverage ranging from 6 to 12 months. The most important thing is for you to see how expensive unplanned emergencies can be and start actively saving for them.

Short-Term Steps to Build Your Emergency Fund Over Time

It will take time to build a robust emergency fund with three to twelve months of expenses. With competing interests like saving for retirement and paying down debt, it can be difficult to find the extra cash needed to build your emergency fund. The following are the first couple of steps you can take in the short-term that will allow you to build temporary cushion for emergencies.

Your first step will be to save $1,000 as soon as possible. As we mentioned above, only 39% of Americans had enough savings to cover an $1,000 emergency. By focusing here, you are giving yourself a tangible goal that will help give you real cushion against any financial emergencies in the short-term. Set up an automatic transfer from your checking account to an online savings account like Ally of at least 3% of each paycheck. Someone making $40,000 would have over $1,000 in one year:

This assumes that your emergency fund doesn’t accrue any interest which isn’t the case especially if you put your funds in an Ally online savings account. As of the date of this article 5/22/19 Ally’s interest rate on their online savings account was 2.20%.

Your second step will be to save all windfall payments you receive like tax refunds or any year-end company bonuses you may receive. In the past tax refunds had averaged close to $2,100, but this year that was down to about $1,950. Even still, you should put this injection of cash directly into your emergency fund and get one step closer to peace of mind.

These steps are meant to help you build a temporary cushion for emergencies in a short amount of time. Once you complete these steps you will switch your focus to paying down debt if you are not debt-free. And once you are debt-free you will refocus on aggressively building a more robust and complete rainy day fund to cover three to twelve months of expenses.

Long-Term Steps to Build Your Emergency Fund Over Time

It will take time to build a robust emergency fund with three to twelve months of expenses. You should view view building enough emergency savings as a long-term project that will get easier as you free up more cash from the burden of life’s expenses. 

Over the long run it will be important that you do two things very well: (1) spend less to save more and (2) make more income. As simple as this may seem, these two factors are the key to building your emergency fund in the long-run.

In order to spend less you will need to build a good budget that helps you cut back on spending. Knowing exactly how much you spend monthly will be key and we suggest using a digital app like Mint or You Need A Budget to track your expenses. The ultimate goal is to bring light to your monthly cash inflows and outflows which will help you free up funds to accelerate the growth in your cash reserves. 

Boost your savings by bringing in more income through a side hustle or part-time job even if only temporarily. Make sure to save any yearly raises received. The average pay raise is around 3%, so a person making $40,000 would have an additional $1,200 to save towards the emergency fund over the next year.

Continue to execute the short-term and longer-term strategies discussed above until you hit your goal of three to twelve months of emergency savings.

Conclusion: Remember It Takes Time

An estimated 530,000 families go bankrupt each year because of medical issues, so it’s clear that medical expenses are a big unplanned life event. On top of unplanned medical expenses, there are a ton of other life events that happen unexpectedly that can derail your longer-term financial plans.

The only way to ensure that you will be truly financially secure in times of crisis is to build  a robust and well-padded emergency fund. It takes some real time and effort to build a robust enough emergency fund that can handle three to twelve months of expenses, but it’s absolutely doable. We hope the strategies detailed within this article will give you a good enough guide to start building your emergency fund.

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Active Investing to Beat The Market is Inconsistent

Purpose of this article: to convince you that a switch to passive investing will boost your chances of hitting your long-term investing and wealth generating goals

Bullet Point Summary

  • Since 1926 the entire gain in the U.S. stock market is attributable to just 4% of stocks.
  • Well over 40% of stocks generated 0% return since 1989 and underperformed even Treasury Bills.
  • To top this off, the top 86 stocks have created 50% of the total $32 trillion generated in the stock market from 1926 to 2015.
  • These improbable sounding stats point to a mathematical principle called Positive Skew, which ensures that only a handful of active investors will pick and own the right stocks that turn into big winners.
  • The Positive Skew of stock market returns ensures there will always be more losers than winners.
  • Consequently, switching to passive investing and indexing is the only tangible and consistent solution to combating the dynamic of Positive Skew.

Overview

I consider myself an educated investor that at best can generate okay to modest returns on average. Even though I take the time to evaluate individual stocks, invest in companies at “the right” price point, and hold for the long-term, I can’t consistently generate over-the-top returns in my active portfolio. And neither can many of my smart counterparts on Wall Street with their enormous informational and financial resources.

Inherently I have always known that trying to beat the market is a fool’s errand. And while books like Fooled by Randomness and A Random Walk Down Wall Street remind me of the difficulties of consistently besting the market, it was an article on Bloomberg I recently read that put the nail in the coffin of active investing for me. 

The thesis of the article is very simple: 

Not only can’t humans outdo benchmarks, we can’t even fight them to a draw.

Why Do We Suck So Hard at Consistently Picking Winners?

While it is important for active investors to do their homework when it comes to compiling an investment strategy the actual reality of the stock market is that all this effort is futile. When push comes to shove the fundamental reason why active investing sucks so hard is that the distribution of returns in the stock market is bizarrely lopsided. 

Because of the statistical principle of Positive Skew (see picture below), only a handful of active investors will pick and own the right stocks that turn into big winners. The rest of the market simply will not. 

By Rodolfo Hermans (Godot) at en.wikipedia. – Own work; transferred from en.wikipedia by Rodolfo Hermans (Godot)., CC BY-SA 3.0, https://commons.wikimedia.org/w/index.php?curid=4567445

The Positive Skew of stock market returns means that there will always be more losers on the left side of the distribution than winners who end up on the right side of the distribution with better than average returns.

History Clearly Shows Stock Picking Losses for Most Active Investors

The math and statistics are simply not in your favor if you are an active investor. The nature of the stock market is such that the odds are stacked against active investors when it comes to consistently picking winners. On average, there will be a small number of extreme winners, a small number of extreme losers, and a ton of stocks that will oscillate around average performance. As a result, most everyone outside of an indexer owns mostly deadbeat stocks.

The following chart from A Wealth of Common Sense shows exactly this as well over 40% of stocks generated 0% return since 1989 and underperformed even Treasury Bills. 

And in 2017, Hendrik Bessembinder found that since 1926 the entire gain in the U.S. stock market is attributable to just 4% of stocks. And to top this off, he also found that the top 86 stocks created 50% of the total $32 trillion generated in the stock market from 1926 to 2015.

Just stop for a second and let that all sink in… And once you have, call your active money manager and request a change in strategy. 

Conclusion: Switch to Passive Investing

For most of us, switching to passive investing and indexing is the only tangible and consistent solution to combating the dynamic of Positive Skew. With active investing comes a much greater chance of underperformance that inherently comes when you attempt to pick stocks. And consequently, active investors need to realize that the statistical disadvantage of Positive Skew is an uphill battle that most of them will lose. 

It’s simply impossible to actually know which companies will be the outsized winners (think about trying to place a bet on Amazon and Google circa 1998). The only real option is a diversified passive investment strategy which spreads your investment dollars across a lot of different companies. This simplistic and effective approach is best positioned to beat the statistical dynamic of Positive Skew in the stock market.