Sarah and I have a large emergency fund by almost any standards. If everything collapsed, we could live for more than a year simply on our cash reserves without touching any of our other investments. That’s a huge emergency fund.
So, why do we have such a big fund? Why not invest some of that money and have a smaller cash reserve?
The simple reason is that it leaves us feeling more secure. Knowing that if everything fell apart we have enough cash on hand to survive for more than a year makes us feel very little stress regarding our finances and our day to day life. If the stock market takes a dive or if something else like that happens, we’re still good to go.
This sounds appealing, of course, but it has a real cost.
As I’ve noted before, the average American family budgets for about $50,000 per year. We actually budget for quite a bit less than that, even with three children. For ease of calculation’s sake, let’s say our annual budget is $30,000 (it’s a nice, even number that’s pretty close to our actual number, which is an odd figure).
Now, I advocate that most people have at least a two-month emergency fund in their savings account once they have their debts paid off. That’s just to make sure that you can survive a short-term job loss or a brake problem with your car or something else like that. (I’d even argue for a bit more than that if you have children.)
That means that we essentially have 10 months extra in our emergency fund. We have $25,000 sitting in a savings account that could easily be in an investment somewhere.
That money makes us feel secure, but what does that cost us?
Our money in savings earns 1.25% (because of the relatively high balance) a year. Let’s assume the money just sits there for 10 years. After a decade, the account balance will be $28,306.77.
Let’s assume that over the long term, the stock market is going to return 7% a year. Let’s say we put that $25,000 into the stock market instead and it actually matches that average over the next 10 years. What’s the total after those 10 years? $49,178.78.
That’s a difference of $20,872.01. That’s a lot of money to pay for a stronger sense of security.
Is it worth it?
I’m hesitant to give a straight “yes” or “no” answer here, but I will say this: This is a perfect example of how personal finance is about way more than numbers.
What’s happening here is that I’m essentially trying to put a dollar value on my own peace of mind and Sarah’s peace of mind. If we move into a situation where we have a small emergency fund and more in investments, not only do we worry a little bit more about our day-to-day problems (like job loss or a car repair issue or a failing furnace… you get the idea), but we also worry more about the volatility of the stock market.
That’s a real amount of added stress in our lives. On the average, we’re financially rewarded for taking on that stress, but it’s not anywhere near a guarantee and it can backfire big time. What happens if the next year is a repeat of what happened in 2008 in the stock market? What if suddenly Sarah falls desperately ill? By choosing to put that cash into investments rather than keeping it nearby, we increase the risk that such events can have a real negative impact on our lives, and that itself causes stress.
You can repeat these exact same questions with many of the ways people choose to spend their money. Is the emotional and personal relief you get from buying a term life insurance package worth it? Is the emotional and personal relief you get from buying a car with high safety ratings to drive your kids around in worth it? Is the security you get from a checkup at the doctor worth the cost and time? What about getting auto maintenance? What about installing a home security system? The list goes on and on and on and on and on.
How much stress is worth how much money? It’s a question that really can’t be answered.
Over and over in life, we agree to add a little bit of stress to our lives in exchange for a little bit more money, but there’s always a limit to it. There’s always a line we won’t cross. We won’t devote every single waking hour to work. We won’t keep all of our cash in a lead box buried 10 feet deep in our back yard. Most of us don’t keep multiple years worth of food in our homes (yes, some do, but they’re in a small minority).
Modern financial life is about walking a tightrope between stress and freedom, between security and opportunity. The answers that work best for me may not work for you. They may not work for anyone else.
For me, for example, I find that having money on hand to live for at least a year no matter what happens makes me feel incredibly secure and lowers my personal stress. Cash on hand beyond that level doesn’t really make much of a difference, but cash below that level sees my stress slowly creeping up. That large emergency fund is the perfect balance for me – it’s at a point where further savings wouldn’t really help much at all, but lower savings would have a negative impact on my stress.
For others, that magic point might be much lower – or it might be much higher. We’re all wired a little differently depending on what we value.
Beyond that, there’s a question of how much a sense of security and a lower level of stress is actually worth as an expense because, let’s be honest, beyond a certain point (probably a few months of living expenses, but that’s debatable), having more cash on hand is essentially an expense considering that the money could likely produce a better return if it were invested elsewhere.
What is a sense of security – whether real or imagined – worth in terms of dollars and cents? What is a slight reduction in stress worth in terms of dollars and cents?
This is the personal part of personal finance, because the answers to those questions depend heavily on you.
How much does stress from having very little savings impact your day-to-day life? Do you lose any sleep over it, or do your stray thoughts go in that direction? How much does a sense of security in having cash in savings help lower your stress and improve your confidence? And how much value do those things have?
For me, low stress and security have a lot of value. I cherish having a relatively low-stress life. My life was far more stressful several years ago and the changes I’ve made professionally and personally and financially over the past few years have all been oriented around having a low-stress life. It’s been incredibly well worth it.
Because of that, I end up using my money sometimes in ways that don’t offer the best financial return. I have that big emergency fund, but I also have a big term life insurance policy. We have a home security system and deadbolts on our doors. I have an annual wellness checkup at the doctor and I see the dentist every six months for a checkup.
All of those things have a cost. Most of those things aren’t strictly necessary for me to live my life. However, all of those things provide me with a lower stress level and an increased sense of security.
Those things are really worth it for me, but are they worth it for you?
My advice to you is to use your finances to address the things that add the most to your stress in life. Stop spending your money on some of the least important things you spend it on and instead use that money to take care of the things that worry you.
Maybe you worry about your health a little. If so, stop by your doctor (if you have health insurance) or a free clinic (if you don’t) for a wellness checkup and maybe start exercising a little more.
Worried about what your family would do if you passed away? Give up some lattes or some drinks or something else minor and invest your money in a term life insurance policy.
Whatever financial need most worries you, address it sooner rather than later. What you’ll find is that your stress level drops and you feel better about your overall life – and that’s going to be well worth it.