Everyone knows you’re supposed to have an emergency fund. You get laid off, break an arm, the refrigerator quits. These things happen, sometimes all at the same time, and so personal finance experts recommend having up to six months living expenses set aside in cash.
But isn’t this advice only for people grinding it out, working and living paycheck to paycheck? In that situation having cash tucked away is smart. There’s no need to slip into debt paying unexpected bills with a credit card charging 15% interest.
For everyone else who has extra money to say, invest each month in a retirement account, they have extra money. Period. In other words, they can cash flow emergencies by diverting money to where it needs to go.
Plus, we overestimate the probability of bad things happening to us. Fear is a powerful emotion. Dilbert creator Scott Adams said it best, “A story of one shark attack makes you think there’s a Great White under every surfboard.”
In reality, what’s the chance you lose your job? According to an obscure measure it’s about 1.5%. That a major appliance dies? Likely a tiny chance too, which is why retailers love selling extended warranties and protection plans. Economist Daniel Kahneman writes about this in Thinking, Fast and Slow:
“People are willing to pay much more for insurance than expected value? — ?which is how insurance companies cover their costs and make their profits. Here again, people buy more than protection against an unlikely disaster; they eliminate a worry and purchase peace of mind.”
Here’s another way to think about this. Pretend some guy comes up to you on the street, shows you a coin, and offers a wager: “Heads you give me $1, and tails I give you $1.” Most people are probably willing to take that bet. The odds are 50/50, and it’s only a dollar.
What happens if the wager was $1,000? The odds haven’t changed at all, but the potential loss has, and when the potential loss is big we become risk averse. It’s the reason people pay more for insurance than it’s worth, and waste money on appliance protection plans.
We know the chances of something bad happening are small. We also know if something bad happens it can be costly. That’s why conventional wisdom is to squirrel away cash for emergencies, but rich people don’t get rich by following conventional wisdom they get rich by investing.
You see, whenever you decide to do one thing with money it means not doing another. This is what’s called opportunity cost. For instance, if you have $25,000 in cash earmarked for emergencies the potential return you’re giving up is your opportunity cost.
Maybe having a mountain of cash helps you sleep at night. That’s fine. However, if the money was invested in the stock market where the average return for all 30-year periods is about 10%, a single $25,000 investment can grow to $400,000.
Doesn’t that difference of $375,000 seem like an enormous price to pay?
This is the logical, rational way to make decisions. You need to know the value of the alternatives you’re giving up. To be smart about what you’re choosing. The only time I’ve had an emergency fund was when saving a down payment for a house. As luck would have it, I haven’t had bad luck.
Look, the downside risk of a big unexpected expense is fairly small, and the potential upside from investing is fairly big. It will always be tempting to imagine the worst possible scenarios and how financially painful they’d be, but the worst thing is probably losing your job and needing to liquidate some investments.
The point of personal finance isn’t to blindly follow whatever generic advice you hear, like picking some arbitrary number of months to keep in cash. It’s to question if the advice even applies to you in the first place. That’s why it’s called personal finance. It’s deeply personal, and different for everyone.
This was originally posted on Business Insider in April 2019. Re-posting it here for a permanent archive.