They say to have 3 to 6 months in a Savings Account
Many a financial guru will tell us that having 3 to 6 month’s worth of expenses in savings is a good idea in case we lose our income, or have some other form of emergency. I agree that having savings outside of a retirement account is a good idea… it’s where we should put that money that I disagree with. Most advisers say we should keep it in a savings account so we can have quick access to it and reduce our risks of loss in a recession. I say rubbish.
Don’t be a Moron
I would have to be a complete idiot to leave 6 months expenses in a savings account for an extended period of time. We’ll have to do a little math to explain why. Let’s say your monthly expenses add up to $3,000 a month, and you’ve decided you want to have an emergency fund that lasts 6 months. First of all, good for you, that makes a lot of sense. Let’s multiply our $3,000 in monthly expenses by 6 months, and we get $18,000. So far so good… your plan is to tuck that $18,000 away in a savings account so you can get to it fast for an emergency. Wait… a savings account? Really?
Pay Attention to your Opportunity Cost
There’s something in the finance World we call our “Opportunity Cost.” This is the the loss of a potential gain we could have made somewhere else. In other words… investing in one thing means you aren’t investing in other things… and those other things might bring you higher returns.
The highest yielding savings accounts right now pay you around 1.5%; the average annual return for the S&P 500 index over the past 90 years is about ten percent. But just to be cheeky, I’m not even going to use the 10% number. Let’s be conservative and say it only returns 7% going forward.
Now let’s say someone has saved up $18,000 for emergencies by the time they’re 25, and plan to keep it there at least until retirement at 65. If they left it in a savings account (currently paying 1.5%) it would grow to about $30,000. And by “grow” I mean “shrink” because 1.5% is less than the rate of inflation, so in reality they would have less than when they started. On the other hand if they would have invested that money in the S&P they would very likely have over $250,000. (and remember we used the conservative 7%)
Where would you rather put your money?
But I Need the Money Fast
Unless you owe gambling debts to the mob, you probably don’t need to be able to get to your money in less than a week. The truth is that it just doesn’t take that long to get to your money these days. I can sell a stock through my broker (I use Ally Financial because trades are < $5) and have the money in my checking account in around 5 or 6 business days. It takes a couple days for the sale to clear, and a couple days for the wire to my bank to clear. So if I had a major emergency I could have money in the bank the very next week. No need for a savings account at my bank.
What if the Market Crashes
This is a valid point. Let’s say you are one of those people with impeccable timing and the day you put all your money in the market it will crash, and 1/3 of your money disappears. While the likelihood of the market crashing right after your invested it, and then you actually needing that money right away is unlikely… it is possible. Don’t worry, I have a solution. I suggest that you multiply whatever amount you want as an emergency fund by 1.5. So if you think you need $18,000, instead save $27,000. Save $27,000 as quickly as you possibly can in your savings account, and then move it over into a brokerage account forever. If the market plummets by 1/3 the next day you still have what you need. I know that part is more work up front than you wanted to hear… but over the years you are just so much better off having that money properly invested. We’re talking about tens of thousands of dollars in your pocket.
How to create an Emergency Account in 3 Steps
- Save 4.5 to 9 months expenses in a savings account as quickly as possible.
- Then transfer that money into an individual non-retirement account with an online broker like Ally Financial.
- Invest in a low fee index fund tracking the S&P 500, like VOO.
C.J. is the blogger behind the Vow of Practicality. “Let’s grow your wealth, increase your productivity, and maximize your happiness.”