Recently, I took a comprehensive look at my portfolio for the first time, and noticed that I was holding a significant amount of cash. Far more cash than I thought! Since then, I’ve even added more cash by withdrawing some money from a pension account. So right now, cash makes up an even bigger portion of my portfolio than at the start of the year.
Currently, I have cash spread across the following accounts:
- Current account #1
Account in my home country, this is where my salary goes and all my bills are paid from
- Current account #2
Abroad, exchange rate is currently unfavorable, so I’m hesitant to lock in that “loss” by transferring the funds
- Brokerage account
I’m investing based on dollar-cost-averaging – I know that lump sum may be smarter, but this feels better to me, and that’s important too. This is why my brokerage account contains some cash earmarked for investing.
- Savings account #1
Designated savings to pay down my mortgages faster. I can make additional payments only once per year, so this account is used to hold the savings earmarked for this purpose.
- Savings account #2
Savings of “fun money” that is left over after each month. This is meant as a saving cushion for “big wants” that would otherwise blow my budget.
- Actual cash
I actually keep some cash at home. Yea really. I thought the COVID crisis might cause a bank run. Talk about paranoia but I’d rather be too prepared than not prepared sometimes,
Ok, so that’s a lot of cash. Sounds like a good problem to have? Well, yes and no.
Holding cash has an opportunity cost. Any money that is lying around as cash is not only not earning interest or dividends, it also cannot appreciate in value. To make matters worse, it actually depreciates over time, thanks to inflation. This means that over time, cash loses purchasing power.
This made me question whether I’m holding too much cash and leaving money on the table by not investing it. Therefore, I made it a goal to understand how much cash I truly need to keep accessible for emergencies, and then invest all the extra cash that is not needed for this purpose.
What’s an emergency?
Let’s start with the obvious – wanting something like a new phone definitely is not an emergency. Piggy from BGR has a great list of questions to establish whether a situation is a true emergency that requires the use of your emergency funds:
- Is something broken?
- Is someone broken?
- Is it impossible for you to fix yourself?
- Will there be legal consequences if you do not fix it?
- Will you lose money, productivity, or your life if it is not fixed?
- Does it need to be fixed right the fuck now?
If you answered “yes” to at least two of these questions, it’s an emergency!
How big should an emergency fund be?
Conventional wisdom says that one should have between 3 to 12 months of expenses in liquid savings to cover any possible emergencies. I’m currently around 16 months, so that is almost certainly too much. But 3 to 12 months is also quite a wide range, and some blogs like Early Retirement Now even advocate having no emergency fund whatsoever.
So what is the right size? I think it depends on everyone’s individual situation and the sort of emergencies and associated costs that one could be exposed to, as well as each individual’s tolerance for risk.
What are some emergencies that could happen?
I’ve tried to collect examples of emergencies that could reasonably happen, and how I would or would not be prepared to react to each of them. Depending on your situation, your list may differ, but for me this was helpful to understand my biggest risks and how much money it would take to address them.
Large, unexpected expenses
There are a few things that would fall into this category for many people. Not all of them apply to me, but I’ve listed them here anyway for completeness.
- Home repairs
My current home is a new built apartment, which means that I have a five year warranty on basically everything. The only expensive thing that could break in my home and that I would be liable for replacing is furniture, such as my TV or my BBQ. These of course would not qualify as emergencies. As my home gets older, I may need to account differently for this category.
For my rentals, one is also a new built apartment (yay), the other is rather old. As there is a homeowners’ association, everyone automatically puts money aside each month to cover any large building-level expenses. If that money is not enough though, I might be on the hook for a larger one-time payment. Thankfully, this is usually known in advance, so that I could save for it ahead of time.
In the apartment itself, the biggest thing that could break and that I would be liable for as the landlord is probably the gas boiler, which would set me back anywhere between 2,000 – 5,000 EUR, depending on the replacement unit and installation costs. So as a very safe estimate, the biggest expense I could need to cover there immediately is 5,000 EUR.
- Health expenses
Thankfully, I have good health insurance. While I do need to pay most regular costs first and then get reimbursed for them, this does not apply for really large expenses (think hospital stay). Should such an emergency happen, it would be billed directly to the health insurance company, and thankfully, I would be covered. Therefore, the largest expense I may need to pay for myself would be around 1000 EUR (think MRI or similar), but I would be reimbursed for this a few weeks later. This category feels rather safe.
- Car expenses
I don’t have a car, so this is not a risk that I’m exposed to. The worst that could happen is that my bike needs repairs or gets stolen. Thankfully, I have a cheap backup bike, so I would not be bike-less in any case. Therefore, I would not need to act immediately, and the total expense of such an emergency would not be very high. This category feels very safe.
Aside from sudden expenses, another emergency that could happen is an income shock. Below is a collection of possible emergencies that might affect my income, and how I could deal with them.
- Job loss
First of all, my employment contract comes with a notice period. That means that I can’t be fired tomorrow (unless I do something insanely wrong and get terminated with cause), but would know about it ahead of time. That would give me time to look for another job, before the next paragraph even becomes relevant. Likely, there would also be some sort of severance money, which would perhaps buffer another month or two.
Thankfully, I also live in a country with decent social security benefits. That means that if I was to lose my job and not find a new one before my notice period expired, my income would not fall to zero. Thanks to the social safety net, I would be able to draw unemployment benefits for a year. While these would be significantly lower than my current salary, together with the rental income it would be enough to cover an emergency budget. I would still be able to cover my three mortgage payments and other fixed costs, as well as bare-bones discretionary expenses (think food, transport), but would not be able to save money.
Given my education and the field I work in, I feel reasonably confident that I would be able to find some sort of job that would pay more than unemployment benefits within a year (plus notice period). So this category also feels somewhat safe, even though it is of course scary to imagine losing your job!
- Rental Income loss
Again, thankfully this is unlikely to happen over night. The rental contracts of course include a notice period, but there is still a risk that the tenants could suddenly stop paying rent. If they give notice in the regular way, I should be able to find new tenants before the contract ends, as the rental market is still very hot in my area. If the current tenants decided to suddenly stop paying, that would be annoying, but the rental income on each property is not a very large part of my income.
Therefore, as annoying as this scenario would be, I could buffer it. If needed, I could even buffer losing both rental incomes at the same time indefinitely (at the expense of savings). Let’s hope it never comes to that, but this category thus also feels somewhat safe.
- Significant disability
This is probably the most worrisome scenario. Should I suffer a significant disability or critical illness that would prevent me from ever working again, that would be an emergency that I would not be able to cover easily. Again, thanks to social security, I would draw some income, but it would not be enough to cover my current costs, let alone additional care costs.
Should this happen, I would likely need to sell at least one rental property. Since I have about 100K equity in one of them, that would be the minimum I could free up in the medium term, likely more (given appreciation minus capital gains tax). That should see me through a few years at least while regrouping
This scenario sucks, but it’s also one that I think would be very hard to cover with any kind of emergency fund. Therefore I’m not too concerned about accounting for this in my emergency fund considerations.
Multiple emergencies at the same time
If I lost my job and at the same time lost rental income and had to spring for a new boiler in the rental property, things might get tight. Thankfully, this is unlikely to happen (hope I’m not jinxing myself), and even if it did, it is likely that I would be able to either find a new job or a new tenant swiftly.
How will I change my cash strategy?
Now that I’ve taken a look at the biggest risks that I may be exposed to, it’s time to revisit my current cash categories and right-size them:
- Current account #1 (home country)
Reduce: My aim will be to dollar-cost-average the cash balance in this account into the stock market as soon as possible. I know that investing a lump sum may be smarter, but as mentioned above, I feel better using dollar-cost-averaging, which I still think is a good strategy overall. However, I’ll increase the amount I invest each month, in order to draw down my cash balance faster. I’ll probably keep roughly 5K in cash balance in this account, because that’s a level that ensures all regular bills plus some minor emergencies can be paid.
- Current account #2 (abroad)
Reduce: I think it’s time to at least reduce the cash balance in this account, even if it means doing so at an unfavorable exchange rate. I’ve been waiting for years for the exchange rate to rebound, and I don’t think it will do so any time soon. Meanwhile, this money is losing value through inflation each month. Might as well put it to work! I’ll maintain a small balance here, because it’s actually helpful to have a local account sometimes when traveling or paying things online in a local currency.
- Brokerage account
Keep: I’ll keep this account but I’ll increase my monthly investments to draw down the balance faster.
- Savings account #1 (designated savings to pay down my mortgages faster)
Keep: In a dire situation, this account can actually serve as a buffer for any rental related emergencies, such as a boiler breaking, and having a designated savings account to pay down the mortgages faster still makes sense to me. Also, this will reset to zero once per year (as I make the extra payment), so this does not really feel wasted.
- Savings account #2 (“fun money” storage for “big wants”)
Keep: I’d much rather tap into my “fun savings” for emergencies than take money from emergency savings to pay for “wants”. So this is another buffer account that is available for me in a dire situation. Moreover, I like keeping this money separate to keep my spending on “wants” in check.
- Actual cash
Reduce: Rationally, there is really no need to keep much cash on hand. This money would not even be available immediately to pay for most emergencies, as mostly these would likely need to be paid by bank transfer. I think the only case where having significant actual cash on hand would help is in case of a bank run, or when the whole financial system / economy is collapsing. I will keep holding on to some cash, but I will reduce the amount of physical cash on hand and invest the rest.
Where will this leave me?
After implementing all the changes to my cash holdings laid out above, I will probably still have between 3-4 months of expenses covered in cash at all times. To me, this feels like a level that I am comfortable with. The 0$ emergency fund is not for me, even if it ERN states that it may be mathematically optimal. But there is definitely no need or justification for my current cash-travaganza either. So I’ll put most of that money to work instead!
Allow me one note to finish up this post:
One word that appears a lot in this article is “thankful”. I truly am thankful that I have the good fortune of having a rather solid social safety net around me and multiple ways to buffer shocks or emergencies if needed. I realize not everyone is in this position and it is important to acknowledge our privileges.
How about you, readers? How big is your emergency fund (target), and have you ever thought of adjusting it? Have you ever had a true emergency that needed handling? How did you pay for the expenses?