Rainy-day fund, as the name suggests, is a fund with money set aside in case of emergency. Since it is for “rainy day” only, not “prolonged pouring month”, such money is not supposed to last for a long period of time.
However, a recent article from CNBC showed that “only 39% of Americans have savings of more than $1000 dollars for emergency needs”. This is quite surprising facts (assuming news on their sites carrying some truth, please note that I did not independently verify such claims).
As an immigrant to US from a different culture, I can’t imagine living a life when I can’t sustain a $1000 setback due to any kinds of breakdowns: car accident, water heater leak, loss of a job, small scale medical bills etc
I think it is important to have certain amount of rainy day fund set aside so that you are covered when such things happen.
Question is: how much is good enough?
We here are conservative value investor so we always try to set a margin of safety when we underwrite anything. In terms of unexpected monetary losses in life, my approach is “unemployment test”.
Assuming for some reason the regular wages stop showing up to the bank account effectively from next payroll date, technically someone becomes unemployed. While your revenue stops immediately, your expenses don’t: you still need to pay rent (or mortgage payments), you need food, you need to commute to find a new job, you probably need to by some clothes for your interviews. You can cut your expenses like Cable TV or expensive dine-outs, but you still need to pay that credit card bill or mortgage if you want to maintain a basic standard of life.
According to St. Louis Federal Reserve, the median duration of unemployment is 8.9 months. Obviously, it is highly correlated the state of the economy: during 2010, the trough of the economic cycle, median duration of unemployment was 25 months, and now in 2018, when unemployment rate is below 5%, still, it takes more than 9 months for half of the unemployed labor force to find a new job.
If you want to have enough cushion financially to prepare for any unexpected events in life that may cost you some money, I would recommend the following:
- Maintain a rainy-day fund of at least 9-month worth of after tax ordinary income.
- If you are not professional in finance industry and you don’t have many venues to manage liquidity, do put the money above in savings account or certificate of deposits. However, if you are confident that you are very experienced investor and you can find many ways to fund any short-term cash crunch, feel free to invest them in public securities (but just be prepared that they may lose value at the same time you lose your job, since both events may happen during a recession)
- Never put such savings into illiquid assets. (it won’t help to start making an umbrella from raw materials when it is pouring outside, and you need to go out in 5 minutes!)
- Have a plan to constantly (maybe every half year) to review your financial situation: if the rainy-day fund is adequate and if the value of the securities that are supposed to be rainy fund is doing fine.
Hope everyone never has a rainy-day moment but just like investing, hope and wish is not a strategy. We need to have solid plans and margin of safety.