Wednesday, March 16, 2011

4 Questions about Building your Emergency Fund Answered


Dear Investor Juan,

I can't say that I'm a newbie in investing but I actually have a mutual fund from PAMI (Philamlife) which is the GSIS fund. I had it since Q1 of 2008 and was able to overcome the global crisis. It gave me a good return of 40+% this year. My plan now is to start investing in equity funds from BPI or BDO for my future goals. But my main concern right now is where to put part of my emergency fund that can give me better return than time deposit accounts. I already know that it must be in safe and liquid form. I am considering SDA, money market funds and treasury bills/bonds. What are your thoughts about it and any suggestions? I am not comfortable with bond funds as its navps/navpu is also changing like the balanced and equity funds so I'm considering it as not safe. Please correct me if I'm wrong.

Thanks in advance. Keep up your great blog! Cheers!


Dear Danison,

First of all, congratulations for earning that huge post-crisis return! Keep up the good work. ;)

Second, I hope you won't mind if I use this post as a venue to discuss emergency funds, in general, even if you have a more specific concern.

Any financial adviser worth his salt would tell you that building an emergency fund is the first stage of an effective financial plan (or second, if you count getting out of debt as the first step): you have to have your emergency fund intact before you can even think of investing in bonds, stocks, or other risky financial instruments. But what is it for? Why do we have to have it? Here are some questions about many people have about emergency funds answered (yours is #4).

1. What is it? As the name suggests, an emergency fund serves as some kind of insurance for "emergencies" or unforeseeable situations where you'll need more cash than you normally do. But unlike the usual kinds of insurance which cover specific events, this one covers everything and anything that can happen.

Because of its specific purpose, your emergency fund would have specific characteristics that would set it apart from other components of your portfolio, as you have already mentioned in your note. First, your emergency fund would have to be liquid enough -- not so liquid that you could be tempted to take a bite from it for "non-emergency" expenses, but accessible enough so you can use it when you actually need it. Second, it should be safe, with no or little risk of loss. Of course, the trade-off in achieving these features is that we sacrifice return, an important issue that we'll go back to later.

2. How does one start? The only way one starts building an emergency fund is by saving deliberately and consistently by making it a priority rather than just a byproduct of spending. To get started, here are a few things you can do to curb your consumption and boost your savings.

3. How big should it be? Looking at the slew of financial advice one can gather from the Internet, we get around 6 to 8 months worth of expenses, but that's more a rule of thumb than a hard and fast rule. The heuristic is based on an estimate of how long it would take you to find another job if you lose your current job: the longer this period is, the bigger your emergency fund should be.

4. Where should you keep it? Remembering the purpose of the fund should guide you in choosing the financial instruments you should consider; liquidity and safety should be your primary considerations rather than return. You're right, bonds and bond funds have no place in your emergency fund as these can be as volatile as stocks and so pose a significant risk of loss. With Special Deposit Accounts (SDAs) -- safe, time deposit-like instruments which feature marginally higher returns for higher minimum required investment amounts -- time deposits, and T-bills, you sacrifice liquidity; you can't afford to have your emergency fund out of reach even for a month, it defeats the purpose. If you really want to earn some return on your fund, I suggest that you put it in a money market fund where you can earn T-bill like returns without sacrificing liquidity too much -- most funds would require you to only pay less than 0.5% if you redeem within 7 days. Finally, if we ignore returns and just concentrate on liquidity and safety, you can just keep your emergency fund in a checkbook savings or checking account; only consider an ATM account if you think you can handle the temptation of having ready access to your fund.
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