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The wisdom of an emergency fund

The wisdom of an emergency fund

01 May 2020

CNBC ran a story November last year, and unless you are a super-fan you probably didn’t see it or notice it. The headline read, “Warren Buffett has $128 billion in cash to burn and analysts can’t figure out why he isn’t spending it.” (1)

As an astute businessman and renowned investor, Buffett clearly knows the value of holding cash or an emergency fund. In his insurance business (Berkshire Hathaway), a cash fund reduces the risk that the company may be overly exposed to a negative event. As an investor, he also holds on to cash in bull (expensive) markets to be able to take advantage of bear (cheap) markets when they eventually emerge.

Back in 2013, Buffett spoke at the University of Maryland and we’re lucky enough that business school professor David Kass, took some notes. As part of his speech, Buffett gave his opinion on the wisdom of holding cash, commenting that Berkshire Hathaway, "always has $20 billion or more in cash. It sounds crazy, never need anything like it, but someday in the next 100 years when the world stops again, we will be ready. There will be some incident, it could be tomorrow. At that time, you need cash. Cash at that time is like oxygen. When you don't need it, you don't notice it. When you do need it, it's the only thing you need." (2)

The above quote sounds prophetic. There will be “some incident” when “the world stops again”. Having nearly 80 years of investing experience (Buffett is currently 89 and bought his first shares when he was 11 years old) teaches you something.

Although Buffett is a billionaire, this is advice that each of us can learn from. Anyone who is working and dependent upon that income to meet monthly expenses should always have some cash set aside for emergencies.

For many New Zealand households currently facing increased employment uncertainty, the COVID-19 situation might very well be one such emergency.

However, it’s our experience that many working Kiwis don’t have an emergency fund. For some, they simply don’t have the capacity. However, for those investors that are fortunate enough to be fully employed, there’s never been a better time to create one.

Without the ability to frequent restaurants or spend on entertainment and travel, the current lockdown may offer a moment in time to save some extra cash. It could be tempting to have a big spend-up when the restrictions lift. However, it might also be the perfect time to create the emergency fund that you have always intended to set up, but never quite got around to.

As a guide, an emergency fund should be large enough to cover your non-negotiable household expenses for three to six months. If you strip away the unnecessary extras and are left with only the essential purchases such as food, petrol, mortgage, insurance, rates, power, etc, how much do you spend every month? Take that amount and multiply by three to calculate what would initially constitute a reasonable target amount to hold in an emergency fund.

Put the money into an account at your bank titled “Emergency” and make an agreement with yourself and with your partner that this money is not for spending on anything but an emergency.

Well known US author, adviser and radio host Dave Ramsey said, “Your emergency fund is not an investment, it’s insurance with one purpose – to protect you and your family.” (3)

So, when should I use my emergency fund?

The rules are simple. If an unexpected expense arises which is urgent, cannot be met out of your normal household account, and cannot be avoided, that is the time to tap into an emergency fund.

For most of us, setting up an emergency fund can’t be done overnight. But, if we think carefully about our spending and savings habits, we can probably put away a little each month and slowly work towards building up a cash fund that will be there when we need it most.

If your situation allows, then now is the time to start. “Because you never know when the day before is the day before… prepare for tomorrow.” (4)