Emergency Fund Review
As my emergency fund grows to around 3 months worth of expenses, I’m starting to think about how to allocate future contributions. I think a good emergency fund should do two things:
The first is obvious! It should provide income incase of unexpected job loss, or a source of funds in a genuine emergency like urgent medical care, home damages that’s not insured etc.
The second is to provide peace of mind that should any emergency occur you’re well covered, at least for up to a year (life, trauma or income protection insurance can also be essential, depending on your age and family composition and could payout well in excess of a year if something really unfortunate happens).
Within a month or two, the fortress fund should be at 3 months expenses, or around $12,000AUD. At the moment, it’s in a high interest savings account, earning 3% interest p.a. I’d like to gradually build to 12 months expenses for the fortress fund. That might seem like a lot, but I’ll do it over a few years. A question that follows from this is where to allocate the extra funds. If 3 months of expenses is in cash (25% of 12 months), where should the other 75% go?
Bonds, cash or stocks?
I’ve decided that the certainty and ready access of cash is important for at least 3 months worth of expenses, so I don’t think will ever change. But the other 75% I’ve decided to invest in a tiered approach, with the second 25% going to Floating Rate Notes (FRN’s), the third 25% to Government & Corporate Bonds and the final 25% to highly diversified Equities.
One caveat – when interest rates are low, like they are now, I’ll Invest by thirds into cash, FRN’s and equities but exclude Government and Corporate Bonds. Bonds would lose face value when interest rates rise. A diversified basket of floating rate notes have typically been difficult to access for investors in Australia, but recently a couple of managed funds and etf’s have come to market. The benefit of a FRN, which is a type of bond is that the interest rate ‘floats’ i.e. isn’t fixed over a set time period. Usually on a fixed-coupon bond (e.g. Government bond) the interest rate is fixed for a given period (say 10 years), and if market rates rise the face value of the bond falls, to compensate for the lower return a new buyer would get, compared to the market interest rate. With a FRN the coupon rate is reset, typically every 90-days and are relative to bank bill swap rate plus some margin. So as interest rates rise, the face value of the bond remains steady because the coupon rate on the FRN rises too.
The tiered approach.
Using a tiered approach means that while the fortress fund is small it will be invested 100% in cash – earning OK interest, but guaranteed accessible and protected by the Australian Government Deposit Guarantee. Only as it grows will it progressively go into slightly riskier investments. These are still quickly accessible, liquid and unlikely to be lost to receivership on the whole. These should offer a slightly more attractive return for the entire holding.
What do you think of this new method?
How do you organise your emergency fund?
Read my disclaimer. I’m no pro!