During the pandemic, saving money has been a hot topic. This is no surprise considering the staggering job losses that affected millions of Americans in early 2020, and the unprecedented number of women dropping out of the workforce due to the stress of juggling work and household duties 24/7. With all of this suffering and uncertainty, Americans turned to their emergency funds for stability, and from March to April of 2020, the US savings more than doubled from 12.7% to 32.2%.
This jump in the savings rate of Americans was well overdue considering most Americans would have had trouble covering an unexpected $400 purchase pre-pandemic, and having an emergency fund is the best way to create financial stability. However, the pandemic has also caused many personal finance experts to change their recommendation for emergency savings amounts from 3-6 months of expenses saved, to 6-12 months of expenses saved, which is just too much.
While saving too much might sound like an oxymoron, it is actually possible and can harm your financial health. Here’s why you need an emergency fund, but should ditch the new savings recommendation and only stash 3-6 months of expenses in it.
Why You Need An Emergency Fund
One word, liquidity. In fancy terms, liquidity means how quickly you can convert an asset into cash at its fair market value. In layman’s terms, it means how quickly you can sell something you own for what it’s actually worth.
Let’s take your house, for example. If you own your home, you can sell it whenever you want, but you’ll have to jump through some hoops before you can get it listed for sale and find a buyer. On top of that, other market conditions will determine how quickly you’re able to attract a buyer. If you need cash ASAP, selling your house at a discount might be the only way to get it. All of these hurdles between the time you decide to sell your house and when you actually receive the cash for it make your house fairly illiquid.
Stocks on the other hand are much easier to sell and are therefore more liquid. There are billions of shares traded on stock exchanges each day, so if you need to sell your stocks, you can usually do it almost immediately. This quick turnaround from when you decide to sell your stocks to when the cash gets into your pocket makes stocks liquid assets.
Since cash is, well, already cash, it is the most liquid asset. Your emergency fund is extremely liquid because it’s full of a bunch of cash. If you need money in a pinch due to a job loss or an unexpected expense, your emergency fund will give you immediate access to the cash you need. This financial cushion is what makes your emergency fund so important. It is your protection against having to jump through hoops to find cash or sell your assets at a loss in an emergency situation.
Why You Shouldn’t Save Too Much
Two words this time. Inflation and opportunity cost.
In fancy terms, inflation is a loss of purchasing power due to a general increase in prices. In layman’s terms, prices increase overall in the US by around 2% every year, which means you can buy less with the same amount of money every year.
Because inflation causes your money to decrease in value, the more of it you have lying around, in this case, in your emergency fund, the more you’ll be impacted by it. This is why saving up to 12 months of expenses is a bad idea. If you saved $60k to cover a full year of expenses in 2020, by 2030, you’ll only be able to buy 70-80% of what you were before and need over $77k to cover the same amount of expenses.
To protect your money from losing its value to inflation, you need to receive a return on your savings that is greater than the rate of inflation. Unfortunately, that’s impossible right now with interest rates being so low, but saving in a high yield savings account (HYSA) is your best option. These offer higher returns than traditional savings accounts and will protect you more from inflation.
On top of inflation eating away at your savings, there is also the opportunity cost of what you could have earned if you had invested that extra 6 months of savings instead. Investing $30k (6 months of expenses based on our earlier example) into an index fund like the S&P 500 would be worth over $81k after 10 years, assuming you receive the average return on the stock market of 10%. By investing that extra $30k instead of saving it, you could earn over $50k instead of losing 2% every year. Since the opportunity cost of saving an extra 6 months of expenses is so high, it’s best to save 3-6 months and invest the rest.
How to Determine Your Savings Goal
Now that you’re convinced you only need 3-6 months of expenses saved, you need to figure out where you fall within that range. To do that, take a look at the variables affecting your cash flow, as well as your risk tolerance.
As a general rule, the more responsibilities and expenses you have, the more you should save, and the more variable your income or cash inflows are, the more you should save. For example, a person with a mortgage and kids should save more than a renter with no kids, and someone who is paid on commission should save more than someone earning a salary.
For a recommendation on how many months you should have saved based on your cash inflows and outflows, download this Savings Amount Calculator.
While the Savings Amount Calculator can quickly give you a savings target, you should also factor in your risk tolerance when deciding how much to save. If your recommended savings amount is 3 months of expenses but only saving that much makes you uneasy, you can always increase your savings goal. In general, the lower your risk tolerance, the more you should save, and the higher your risk tolerance, the less you should save.