Emergency Funds are Nothing to Sneeze at

March 23, 2020

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Life happens and we know all too well that the ride is not always smooth and predictable. In March, 2020 we are all living through one of the biggest bumps in that ride that we may have experienced in our lifetimes – the COVID-19 Pandemic. As of this writing, the stock market is down some 35% and many businesses in the US are grinding to a mandated halt. All of this was completely unimaginable only weeks ago. Millions of people are losing income and many will lose their jobs entirely.

Today, it’s a virus, but tomorrow it could be a flood, a fire, a business crisis, an earthquake…we all know the possibilities. We just don’t dwell on them. We buy insurance on things we can insure -- our health, homes, cars, and lives. We then proceed as if such calamities will never affect us and we rely on a support system of some kind to somehow take care of us when the chips are down. As times like this tell us,that isn’t always enough.

That’snot to say we are ignorant or naïve about risks. We’re just being human. Underweighting the probabilities of catastrophic events is a documented behavioral characteristic of our humanity. Unfortunately, this also causes us to under prepare ourselves financially.

Emergency funds are a simple concept, but a challenging implementation. We need to begin creating it when we are young and that of course is the most difficult time for us financially. Six months of living expenses (the common recommendation for emergency funds) is a huge hurdle for people struggling to save for retirement, buy their first home, or just make ends meet under expensive urban living conditions.

How much to set aside

Six months of regular monthly expenses is a good target. That could be in the range of $25-30,000. But frankly, the exact amount is less important than the idea of just getting something socked away and adding to it. You don’t want the idea of a six-month target to seem so daunting that you don’t start putting in anything in at all.

Whether you come up with six months’ expenses or another number, you’ll likely be more successful at it if you at least initiate it with something up front and devise a plan for how you’ll add to it. Here are some ideas for doing that:

   -   Add part or all of your tax refunds
   -   Add money from any raises you get
   -   Add your small change every week or so (piggy banks for spare coins can         actually help!)
   -   Set up a weekly or monthly bill-pay or transfer to your emergency account
   -   Give up a going-out-to-eat night now and then and put the equivalent into         the account
   -   Put in money from expense reimbursements

Use Behavioral Science to your advantage

Building up an emergency fund is generally perceived as a nice-to-have and prioritized well below regular expenses, saving for a home, and other important items. Unfortunately, as priorities change, the emergency fund tends to remain at the bottom and off the radar screen. As long as there is a perception that the likelihood of an emergency is low, it will generally remain commensurately low in priority.

You’ll also notice that the suggestions above have something in common – they all involve taking money from someplace other than your primary checking account.There’s a reason for that. Its because taking money from your primary spending account is the hardest to do and the method that too often places the emergency account at the bottom of the priority list.

You can use cognitive bias to your advantage here. Set up a separate account,preferably at a different bank than you normally use. Then have a small part of your paycheck direct-deposited right into that account. Chances are you won’t miss the money and you’ll simply adjust to what you have in your primary checking account for discretionary spending. It works the same way as withholding for taxes. When you don’t see the money it becomes “out-of-sight,out-of-mind’ and that’s related to anchoring and mental accounting.

Most importantly, recognize that at some point, you will very likely need to tap those funds, whether it’s an unexpected transmission repair, a broken pipe, or a skiing accident. By setting up your own emergency fund, you are essentially self-insuring yourself against things you normally can’t buy insurance for.It’s the type of thing you would recommend to those you know, so why should you be any different?