In the world of investing, a “black swan” is an unforeseen event with devastating consequences. These events often strain the financial capabilities of families and households. The spread of the Coronavirus and the resulting shutdown of the economy constitute a black swan that is having terrible effects on work, income, investments, and every other aspect of our lives. The federal government has passed a $2 trillion aid package to help, but its effects are not yet clear. At times like this, it is important for everyone to have a financial plan that includes an emergency fund.
An emergency fund is savings that is able to cover three to six months of living expenses. This is not a random range. The emergency fund is meant to cover a period of unemployment, which lasted, on average, about 21 weeks for Americans who became unemployed in 2019. The emergency fund is there to get a household through a hard time when the cashflow dries up.
But, creating an effective emergency fund can be difficult. One reason is that while other important areas of saving have dedicated savings instruments with special benefits, like
retirement savings have IRAs and 401(k)s, education savings have 529 plans, and medical savings have health savings accounts, there is no special instrument for emergency fund saving. Building an emergency fund is simply a matter of dedication and personal discipline.
Though it may be counter-intuitive, an emergency fund should not be invested in the market, but should instead be held in an extremely stable asset, typically cash. While investments may be available for a personal emergency, a broader crisis like the coronavirus may shrink the value of investments and diminish the effectiveness of the emergency fund. When it comes to an emergency fund, find an accessible money market savings account at a trusted bank.
Facing a black swan without an emergency fund may be difficult, but there is still much that can be done. First, assess all possible sources of cash and credit. While it may not be advisable to open a new credit card, it is worthwhile to know the limits of existing cards. More appropriate may be to open a home equity line of credit or borrow against a 401(k). Consider filing a tax return early if expecting a refund. Any cashflow that can reasonably be saved should be saved. Even a few hundred dollars can make a big difference.
Next reduce spending. Belt tightening may be bitter medicine, but when facing economic difficulties it is often essential. Consider cancelling subscriptions or switching to a less expensive cell phone plan. Temporarily reducing contributions to retirement plans may also be appropriate, though that should be a last resort. Carefully plan a budget and stick to it. An effective reduction in spending should help the new emergency fund last longer.
The coronavirus is an unprecedented event that is having an extraordinary impact on the economy. But every indication is that this will pass and eventually the economy will return to normal. When the coronavirus is over, start preparing an emergency fund for the next black swan.