Someone asked me this question via email, and I'm sharing my answer here. Partly because it might be helpful to others, but mostly because it doesn't hurt to get different viewpoints and answers on a relatively complex problem.
But first, for better context, here's the question:
Bumped into your blog when I was doing some online research on investments and other money matters.
I have been trying to decide on: investing money on mutual funds or saving up for emergency funds first.
Honestly, I am in my early thirties and I already have 3 children and this is the only time where my family have had enough responsibility and financial wherewithal to start thinking about these things. The previous decade has been "firefighting" mode.
Most blogs, including yours, recommend I save up for emergency funds before investing on stocks or mutual funds. Before even buying insurance.
But that's like 600,000 to 800,000 in a bank. Every month. With little to no interest gained over time. It would be sort of a waste if I don't invest that into money markets.
For emergencies, I have good credit anyway which mean I could take out a loan easily. I am also a member of a cooperative which also provides loans at rates as low as 1%.
Thoughts?
Make this opportunity count
You mentioned you've been in firefighting mode for the past years, I can relate to that; I'm sure a lot of people can. However, you and I seem to be looking at it differently.
My impression is that, in your view, after a decade of firefighting, this is now your chance to make something happen with your money. You should "make it count" so to speak.
My thinking is a little different. What if the next "fire" is a big one? I could borrow money, and I'm sure my family would not begrudge me. But that doesn't mean I won't have to pay them back. I’ll just end up in firefighting mode again.
The way I see it, a high-risk, high-return equity fund won’t be the best bet to make this opportunity count. To really make this count, what we need is a “firewall”.
That way, even if the next “fire” is the biggest one we’ve ever experienced, we have a good chance of getting out unscathed – meaning, we’ll still continue to have money for investments.
That means health insurance, life insurance, and maybe even some property insurance if it's warranted. But not everything is fully covered or fully replaced by insurance. And some "fires" just can't be answered with insurance. Sometimes we just need cash – emergency funds.
Credit is good but you need cash
Loans and credit cards aren't really emergency funds. Lines of credit from a bank might be; if there is no further approval necessary, and the funds can be handed to you almost automatically.
Emergencies tend to happen without prior notice, and require action immediately. For example: a sudden hospitalization, but the procedure isn't covered by your HMO (or at least not fully).
Say someone hit their head. A neurologist is very expensive, and no HMO in the Philippines covers them (apparently a choice of the neurologists). Or a car breaking down in the middle of nowhere. Or getting stuck in the province, where credit cards might as well be moon rocks.
Those emergencies might be far-fetched; but there are times that you just need cash.
If you feel bad about your money sitting in a bank, you shouldn't. The larger it is, the larger your safety net is. If anything, it should make you happier.
Making the most of your emergency fund
But there is a way to not just let it sit there. Save up for a month’s worth of expenses. Keep that in a savings account (preferably an ATM account, with a bank that has tons of ATMs near you and pretty much everywhere you go). If it's large enough, go for a high-yield savings account.
After saving up for a 2nd-month’s-worth of expenses, put that in a money market UITF or mutual fund. It's not even close to an equity fund in terms of returns, but it's as safe as a UITF or MF can get. Just find a UITF/MF with a holding period of less than 30 days.
If you can't find one, place the money in a time deposit with a 30-day term. Preferably in a bank that is very, very accessible to you. If it's large enough, keep them in separate TDs and ladder them to keep you liquid.
Once you save up for a 3rd month, place that in either a UITF/MF or a Time Deposit. (Whichever is more accessible, and has a holding period of 30 days or less.)
And once you have 3-month’s-worth of expenses in your emergency fund (across various instruments), you can now split your savings - half for your emergency fund and half for your investments.
(At this point, start shifting more money into the savings account, you can decide the pace, but I'd suggest at least half your fund always be in the savings account.)
You can decide on the right allocation for your savings, but getting your emergency fund to cover 6-month’s-worth of expenses is very important.
Just think, if you (and/or your wife, if you are both breadwinners) lost your job, how long would it take to find a new one? And where would you get money for food, electricity and tuition in the meantime?
Once you already have 6-months-worth of expenses in your emergency fund, you can now place a larger part (or even most) of your savings in the investment fund. But keep placing money in your emergency fund. Partly for inflation and lifestyle creep, but mostly because you can never tell how big the next “fire” is – and therefore how big your “firewall” needs to be.
Slow and steady wins the race
In this strategy, you get some return despite building your emergency fund. And those returns in turn can help build you fund faster, with very minimal risk (though your liquidity suffers a bit).
It's small, but the strategy is safer. (Not as safe as keeping it all in a savings account, but since we're discarding that approach...)
What happens to your 600k, if you placed it in an equity fund and the next big correction happens? It's only a paper loss, but it becomes a real loss if you need to redeem it at that time due to an emergency.
Not only did you have to pay for the emergency, but you lost money on an investment as well.
Alternatively, instead of a rule-of-thumb target of 6-months-worth of expenses, you can list down all the bad things that can happen and how much it would cost you. Just be careful not to be too optimistic.
(In my unsolicited opinion though, since hospitals and illnesses are usually involved in such considerations, you probably won’t go lower than 500k, which isn’t too different from the 600k you mentioned.)
Another alternative is to place a small amount of your savings in the equity fund. Maybe 10% of what you save? Or maybe just enough to open one and top it of every month? It's up to you, but building the emergency fund is still the most critical task.
In the end, it's really up to you. But I hope you reconsider your feelings about your emergency fund. After all, financial security is about not worrying over money, not necessarily making lots of it.
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