Sunday, April 4, 2010

Importance of emergency cash reserves

I have a policy of keeping sufficient cash reserves to meet life's misfortunes. The common risks in life that I can think of are unemployment, medical illnesses, accidents. Risks such as medical illnesses and accidents can be transferred away through insurance. Insurance premiums are fixed costs, so they make financial planning easier as they bring more certainty to the specific risks. This helps one to reduce the size of the cash reserves to be set aside. Generally, when the risks are more uncertain, one has to set aside a larger cash buffer for protection.

In the event of unemployment, I set aside 6 months worth of cash to meet expenses which cannot be avoided. This includes basic living expenses, debt payments and parents' allowances. Although my parents will probably refuse to accept any money should I become unemployed, I think it is a good policy to set aside this money anyway.  Children have a greater chance of becoming filial when they grow up when the parents exhibit similar behavior themselves. Therefore, undisrupted payment of parents' allowances despite adversity is a good policy of securing one's retirement in old age because it nurtures filial children who provide retirement support.

As a person grows older, I think 6 months worth of cash will not be sufficient for protection. For the average worker, it is harder to find a job if he gets retrenched at an older age and even when he does, a pay cut is almost inevitable. Therefore, he should set aside at least 10-15 months worth of funds as he grows older depending on how confident he is in finding new sources of income soon.

Besides unemployment, there are other risks in life that cannot be insured away. One risk that presents particular headache to me is parents' and parents'-in-law medical bills as they near the end of their lives. It is very hard to estimate how much this will cost because it depends on how they die. If they were to die a slow death, organ by organ, the doctors will eat up my nest-egg. Because of the uncertainty, one has to set aside an out-sized amount. It is a burden that one has to carry to avoid the regret and guilt of causing the old folks' deaths by denying them medical care. The younger generations of Singaporeans will have to bear even heavier burdens as parents have fewer kids and their life expectancy lengthens. It is incumbent on every parent to start preparing for their retirement to prevent such issues from souring family relationships.

On top of the cash reserves that I set aside for the above considerations, I added another 10%-15% as a margin of safety to meet life's unknown or even unexpectable risks. I think this is reasonable because no one can think of all the possible risks ahead.

Those who invests in the stock market may be tempted to put the emergency cash reserves into it. Indeed, I was tempted when I started out in the stock market. Thankfully, I did not. Like most amateurs, I lost money. However, at no time did I put my family finances in danger because the cash reserves were untouched. An advantage of having ample cash backup is the psychological support it provides which gave me a cool head while others in the same predicament were losing theirs. This is very important in investing as the right psychology plays a big role in success. An investor who becomes disheartened by losses will not be able to recover his losses when the bull market returns.

Some newbie investor will ask "what if they do not have such a cash reserve"? Then, don't invest. My order of priority is to first, buy insurance for protection, then save hard to build up a sufficient cash reserve and finally, invest the rest which represents money that can be lost 100% without danger to the family's finances.

1 comment:

  1. I think that emergency fund is a necessity to everyone. You never know what will happen tomorrow and that’s why it’s important to have some savings for a rainy. But unfortunately, almost third part of Americans doesn’t have any savings and fill paydayloan application to get cash in emergency. It’s important to save money to feel financially confident in different situations. That’s why setting emergency fund is a necessity for those who want to avoid unexpected financial problems and borrowing. Set yourself a goal and on every payday put some amount of money to your emergency fund.