Bad things happen to good people. Houses burn down or flood. Cars get totaled. Physicians are served unexpected divorce papers. Extended family members get huge medical bills that they can’t pay. You need to prepare for these unlikely but unanticipated events by keeping 3-6 months of living expenses in conservative investments that you can access in an emergency.
While most people recommend you accumulate an emergency fund, nothing is ever straightforward in the world of finance, and even something as bread-and-butter as an emergency fund can be controversial. Below are the aggressive and conservative approaches to establishing an emergency fund.
The Conservative Approach
There are many places you can park your emergency cushion. Savings or checking accounts are Federal Deposit Insurance Corporation (FDIC) insured and offer immediate access to your money, even via ATMs. The downside is that the historic yield on these investments usually does not keep up with inflation, so you lose purchasing power over the long haul. Money market mutual funds are the most recommended place to park your emergency reserves as they offer higher returns and allow you to write checks above certain amounts (commonly $250 or $500), giving you immediate access to the funds when you need them. Unfortunately, the yields on money funds are at a historical low and not consistent with their approximate 3% historical average that would normally keep pace with inflation. Keeping emergency money in certificates of deposit is probably not a great idea, as you’ll pay a penalty if you access the money early.
Not all savings accounts or money funds are the same, and if you shop around you can find a better deal. For accounts offered by banks, check bankrate.com. As I write this, the yield on savings and money market accounts ranges from 0.05% to 1.01%. For money market mutual funds, which are not FDIC insured but are almost as safe, check mutual fund companies. Commonly recommended company websites include fidelity.com, schwab.com, tiaa-cref.com, troweprice.com, or vanguard.com (my favorite). Important things to look for are the minimum initial investment, the smallest amount you can write a check for, and the expense ratio (the lower the better). If you find yourself in a higher tax bracket, usually 33% or higher, it may make sense to use a tax-exempt money market fund that invests in tax-free state and municipal bonds. These tax-exempt funds may offer a higher after tax return, and some are targeted to the residents of particular states and offer state tax benefits as well. The mutual fund companies can usually help you decide which of their products is best for you.
The Aggressive Approach
The aggressive approach is to keep a smaller amount in reserve, 1-3 months of living expenses for example, and invest it more aggressively. You could keep 1/3rd of it in a money market fund, but the other 2/3rds could be invested in a stock or bond fund or some combination of the two that will yield a higher return. This will allow your emergency fund to grow as your income grows, possibly reaching the recommended 6 months of living expenses or more. If you need more cash than what is in your emergency fund, a physician can usually borrow the money by using a home equity loan, for example, or a credit card. Credit cards, obviously, have higher interest rates, but this is an aggressive approach and you probably won’t have to borrow any money at all.
What Should You Actually Do?
Only you can decide what is right for you. For example, as Navy physicians we all have full medical insurance for our whole family through Tricare, and have as much job security as any physician can have. I’m not getting fired (or at least I don’t think I am). As a result, my emergency fund usually resides in the low end of the 3-6 month range, as there are very few emergencies I expect to have to deal with. On the other hand, if I was a civilian and worked as an independent contractor, provided my own health insurance, and felt that my contract could be reduced or eliminated at any time, I’d probably have 6 months of living expenses (and maybe more) providing a more substantial cushion.
Whether you take a conservative or aggressive approach or somewhere in between, what is clear beyond a doubt is that you and your significant others need to come up with a plan for emergencies that makes sense for you and allows you to sleep at night.