The emergency fund: Concept, importance, management and amount

The financial emergency fund

A question that I have been asked many times since the beginning of the Investment Academy ago. more than 5 years (How time passes!) Is what percentage of our savings to invest in the stock market. My answer is always the same, invest the money that you will not need in the short or medium term. To delve a little deeper into this topic, it is important to understand the concept of the emergency fund.

In this article I will explain what the emergency fund consists of, the importance of having it, its recommended amount and how we should manage it.

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  • Free Introduction to Stock Market Investing Course), I always have a certain amount of money in liquidity. This allows me to cope with unforeseen expenses without having to forcibly sell shares or take out a loan to get ahead.

    In which cases should you go to your emergency fund?

    It is important that you realize that the money that is part of your emergency fund should only be used to cover unforeseen expenses that are beyond your control.

    Some examples are the following:

    • A mechanical breakdown of the car
    • A home repair
    • Suffer a layoff
    • The bankruptcy of our company

    In no case should you use this money for expenses that you already know you will have to face. If you know that you are going to spend € 3.000 each year on vacations, that money should not be taken out of the emergency fund, since it is a totally predictable expense. Therefore, you should create a fund for holidays throughout the year, separate from the emergency fund. The same happens with the payment of insurance or the return to school of the children.

    If you see that in a few months you are going to have to face a significant expense and you do not have enough liquidity, you may need to ask yourself if you should undo an investment if it is a good time to do so. Another alternative would be to increase your savings ratio by temporarily reducing your unnecessary expenses.

    Why is having an emergency fund so important?

    There are 2 main reasons why you should have an emergency fund.

    First, avoid the costs of borrowing. Covering this type of exceptional expenses through indebtedness implies an additional cost that can, at times, touch the limits of usury. For example, Mister Market is depressed and buys them from you for a price well below his intrinsic value.

    How much money should I have in the emergency fund?

    There are different theories about how much money should be kept in the emergency fund. Although there is no single criterion, a fund capable of covering 3 to 6 months of current expenses is usually recommended.

    Although this is the general rule, it is necessary that you take into account your personal circumstances to determine the money you should have in your emergency fund. For example, for a civil servant couple without children, an emergency fund of 3 months of expenses may be more than sufficient. In contrast, for a family where only one of the spouses has an unstable job, a 6-month emergency fund may even fall short.

    How should I manage the money in my emergency fund?

    The money from the emergency fund must be deposited in a place that meets two requirements:

    • That it has immediate liquidity, that is, that it can be withdrawn at any time without involving a significant cost
    • Maximum security. We should not seek profitability, but rather minimize risk to maintain our purchasing power in adverse circumstances.

    For example, you can have your emergency fund in:

    • Short-term monetary funds
    • Current accounts
    • Cash

    Now you know what the emergency fund is, you know its importance, the amount you must deposit in it and how to manage it. If you don't have an emergency fund, now is the time to start creating one. It will not avoid possible extraordinary expenses or specific labor problems, but it will help you avoid financial crises that irreversibly damage your wealth management in the long term.