WCI #18: Emergency Funds

This is the White Coat Investor Podcast where we help those who wear the white coat get a fair shake on Wall Street. We've been helping doctors and other high income professionals stop doing dumb things with their money since 2011.

Here's your host, Dr. Jim Dahli. Welcome to podcast number 18 emergency funds.

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Can help welcome to this episode of the podcast. I'm glad you're here. I suspect a lot of you are commuting or exercising or otherwise bettering yourselves while listening to this in the background. So we'll try to not make it too heavy today. A lot of these episodes kind of get a little bit heavy, but we'll keep it a little bit lighter today. We're going to be talking a lot about emergency funds, which turns out to be a surprisingly controversial topic. But we've been having a lot of fun here at the White Coat Investor lately. We've got our scholarship contest going right now. If you'd like to get a whole bunch of money for med school or dental school or other professional school and you're currently a full time student in good standing, you should be sending us what's basically a guest post on the blog and the top five of these win prizes. The top one's likely to get something like $15,000 in cash to help reduce their debt burden for school. And so if you haven't applied for that yet, please do. You have until August 31st this year. Also, if you'd like to be a judge, you can't be a student and be a judge, but if you're a professional now into your career, you can qualify to be a judge. And we could sure use some more volunteer judges. So either way we please send an email to scholarshiphitecoatinvestor.com we're also very appreciative of our platinum sponsors for this scholarship, these include Larry Keller at Physician Financial Services, Darian Reweithen bank, which is recently rebranding and will be calling itself Laurel Road, Michael Relvis with Mr. Insurance locumstory.com and Jamie Fleischner at Set for Life Insurance. I'm grateful for all of these platinum level sponsors, all of whom chipped in at least $3,500 cash toward this scholarship. So I'm grateful for that and I'm sure the recipients will be, too. But let's talk about emergency funds. I had no idea this was so controversial. It seems like this year there's all kinds of bloggers out there in the blogosphere who are writing about how emergency funds are stupid. Well, I don't know that they're stupid, but I think there's a lot of gray in between the two positions you see people taking these days. I mean, let's just outline the two camps in this debate, Right? Right. Let's start with the Dave Ramsey camp. And this is basically the camp that says you need an emergency fund to keep you from going back into debt. I mean, if you look at what Dave Ramsey recommends, he says save up a thousand dollar emergency fund as baby step one. Then in baby step two, you pay off all your debt, everything, cars, credit cards, family debts, home equity loans, and even student loans, even if you owe three or four hundred thousand dollars. He puts all that in baby step two. And then his baby step three is to save up an emergency fund equivalent to three to six months of your expenses. Only after that does he recommend you start investing. And so that's kind of the camp on one side. And basically the idea is that that emergency fund helps you keep from going back into debt and teaches you how to, you know, start living on less than you own. The other camp argues that there is serious opportunity cost in having money sitting around in a very safe investment like people typically use for an emergency fund. Basically, they look at, you know, today's Savings accounts paying 1% and they say what's the point of leaving money in there when you could invest it in real estate or stocks or whatever and make 3, 4, 5, 6, 10, 15%, something more, you know, and they run the numbers out over 30 years and point out that if you make 10% instead of 1% over 30 years, you end up with a lot more money. And that's obviously true, but I think it's important to look at the big picture with this. I did a poll of readers at the end of a recent post and 80% of them have a traditional emergency fund of three to six months of expenses in some sort of a safe investment. And so I think it's important to have an emergency fund. I think it's a good idea, but I don't think you need to be dogmatic about it. So let's talk about a few things here. I mean, what is the purpose of an emergency fund really? Well, the first purpose is to probably teach you to save a little bit of money. You know, this is really hard for Americans, not just doctors, but all Americans. It's hard to save money. Most people in this country are basically living hand to mouth. And it's not due to lack of income in most cases. Obviously in some cases it is because they're just not making anything. But there are lots of people making a very good income who aren't saving any money. They simply spend all their money. And so an emergency fund, you know, the process of building one, will actually teach you how to live on less than you earn. I think that's useful. It also keeps you from having to sell investments in a down market. For example, if the stock market tanks 50% and then your washer and dryer both go out on the same day, well, you've got some liquid cash that hasn't dropped in value anytime recently that you can use to buy a new washer and dryer or whatever your emergency may be. And so that's the benefit of having that money invested in a very safe way. An emergency fund also helps you avoid liquidating illiquid investments. Now, many of the investments I recommend around here, like index funds, can be liquidated within a matter of two or three days. It's really not terrible. But if you have investments that are in small businesses or real estate properties, liquidating those can be a major hassle. It can take months and cost thousands of dollars to get out of it. And so having some cash on hand allows you to not liquidate those investments at fire sale prices. Another important purpose of an emergency fund is to help you avoid going into debt for an expense. You know, transmissions don't always announce when they're about to go out and all of a sudden you've got a four or five thousand dollar expense you've got to come up with right away. Now if you didn't have an emergency fund that might go on your credit card where it starts earning, you know, 15, 20, 25% interest right away, which is obviously a terrible investment. But if you have that money sitting in an emergency fund that is no longer such an emergency, it's just an expense and you pay for it out of the emergency fund. But I think the most important purpose of an emergency fund is it allows you to take risk, risk in your life. And I'm not just talking with your investments. It does allow you to take investment risk knowing that you have money that you need to live on. Set aside allows you to invest in, you know, risky index funds and risky real estate investments and those types of investments without having to worry about where groceries are going to come from two months from now. But more importantly, it allows you to take risk in relationships, in your job, in your business, in starting new businesses. All of that allows you. Having those emergency funds allows you to take risks that you otherwise might not be able to take because you know, you've got, you know, payments due next month. That psychological backstop is pretty useful. And plus, you know, you can take a lot more risk in your career when you've got walking money or FU money in your pocket. A lot of people, you know, and most of them tend to be fairly well to do and fairly financially sophisticated, feel like future earnings and borrowing can take the place of an emergency fund. For example, I saw a blog recently from Early Retirement now and his emergency fund or plan, really, it's not really a fund, it's a plan of what he's going to do if there's an emergency is to use the float on his credit cards. Right? Because if you put something on a credit card, you got a few weeks before you have to pay it off and then to use his next paycheck to use a home equity line of credit and then to tap his investments. Well, I mean, it's good to have a plan, but it's not really an emergency fund. The problem with that plan is it doesn't line up very well with what I see as the purposes of an emergency fund. If your purpose of your emergency fund is to avoid selling investments in a down market, then your investments don't make for a very good emergency fund. And if the purpose of your emergency fund is to avoid going into debt, then going into debt isn't a very good emergency fund. In fact, in a lot of ways, if you've got debt and an emergency fund, you've already had the emergency, might as well take the money out of the emergency fund and pay off the debt. I mean, if that's the purpose of your emergency fund. So the other problem is when it rains, it pours, right? When you have an emergency, let's say it's a medical problem, you know, there's more that comes with that than just the medical expenses. You also may not be able to work. And so you've got the loss of income coupled with this new medical expense. And so I think it's important that you realize that it can really get bad in a hurry. And having those expenses set aside can really take a lot of pressure off in those instances. And using your future earnings as an emergency fund, I mean, really, that is such an unstable thing. Even in medicine, where our jobs are fairly stable, I don't think relying on future earnings for your emergencies is really any kind of an emergency fund at all. That's just life. But here's the deal, right? If you are halfway to financial independence or you're already retired, do you really need an emergency fund? No. I mean, you're financially independent, you got 2 or 3 million bucks in the bank. You know, if something big comes up, you just go take from your investments and you pay off the expense. So at a certain point, I guess, you know, everybody doesn't need an emergency fund their entire life. But you've got to realize that in the beginning, when you don't have a lot of cash, when you don't have a lot of investments, that's when the emergency fund is most useful. In a lot of ways, it's like insurance. It allows you to take risks that you otherwise couldn't take. But also like with insurance, if you're a really good saver, you have good financial muscles, eventually you grow out of it and you can self insure that risk. Just like insurance, it's not about the return on your money. You're supposed to lose money for insurance, right? And so keeping a certain small amount of your portfolio in cash as an emergency fund is like an insurance policy that you know you're going to lose a little bit of money on it because it's not earning 10%, it's only earning one. So I have a lot of people ask, how should you invest your emergency fund? And just like people look at emergency funds from a lot of different angles as far as what their purposes are, people invest them in lots of different ways as well. So. So there's no definitive dogmatic way that you have to invest in an emergency fund. But if one of the purposes of your fund is to avoid selling risky investments when they're down, then you can't invest that emergency fund in those risky investments. So an emergency fund really starts at the basics, right? It's what you have in your house that might be cash, maybe even in Multiple different currencies. In a safe in your house, it might be some canned food and some stored water and a generator and some gasoline and an AK47 and some bullets. You know, I mean, that's really an emergency fund. But, you know, most people don't keep all that much cash in their houses. And so a typical emergency fund is going to be invested in something like a high yield savings account or a money market fund, maybe a tax exempt money market fund for a physician or somebody else in a high tax bracket. And, you know, your money in your checking account can also count toward that. And so that's the lion's share of most people's emergency funds is their checking and savings accounts. If they want a little bit of a larger emergency fund, maybe they're one of those types that wants six months in an emergency fund. Maybe the first three months or, you know, the first month's in cash in the house, the second month's in checking, the third month's in savings, and months three through six are in CDs or short term high quality bond funds, that sort of a thing. But the point is not to put them in the risky portions, not to put this emergency fund in the risky portion of your portfolio. This is not money that really should be invested in stock index funds or in, you know, real estate. I saw a guy writing a blog post the other day and his contention was that rather than keeping an emergency fund in, you know, a savings account, you should invest it in a moderate mix of stocks and bonds. But rather than only putting the amount you want in the fund, you should put some amount larger than that. I think the number he used was 130% of the amount, which is kind of silly. His idea was, well, even if it dropped by 30%, you'd still have the amount in your emergency fund that you needed. But, you know, at this point, you're starting to fight against dogma, and you don't need to be dogmatic about an emergency fund, but I think it's a good idea to have something safe sitting around to use in situations where it can be useful. One thing that I don't think qualifies as an emergency fund is a health savings account. Really, there are pretty onerous penalties on pulling money out of an HSA if you're not spending on health care. Now, if you're one of those folks who has been keeping track of receipts so that they could later pull money out of an HSA tax and penalty free, that's a different story. If you've got you know, $20,000 worth of receipts. Maybe that HSA can function as your emergency fund, but if you don't have that, I don't think you should be using your HSA as an emergency fund. I mean, medical expenses are an emergency, but they're certainly not all the emergencies. I mean, really, the arguments against an emergency fund come down to opportunity cost. And by the time you get to be a financially independent person, the opportunity cost on having three months of expenses earning only 1% is pretty darn low. It just isn't going to move the needle on whether you retire, you know, this year or next year. It's not enough money. And so I think it's okay to have some money sitting in an emergency fund, even though it's not earning much money. It's a terrible truth, but really, the poorer you are, the more you need an emergency fund, the harder it is to accumulate and the higher its opportunity cost by the time you're rich. And it's easy to acquire an emergency fund. And the opportunity cost is no big deal. You don't even really need it. And so it's really an unfortunate dichotomy there. I know back when we didn't have all that much, you know, I don't know that you could call us poor, but we certainly weren't rich yet. We tried to get an emergency fund, and we usually had a few thousand dollars sitting around somewhere, whether it was checking or savings or something like that. But come January, we generally rated it to max out our Roth ira. I'd tell myself, well, you can always pull out a Roth IRA contribution at any time, tax and penalty free. And so, you know, in some ways that functioned as an additional emergency fund. But the truth is I wasn't investing it in safe investments. I was investing it in stock index funds. And so it really didn't function as a true emergency fund. By the time we actually had a true six months worth of expenses emergency fund, I think we were millionaires. We were seven years out of residency. And so I think there's room to fudge this a little bit if you want to raid your emergency fund to max out your Roth IRAs and then you build it back up later in the year. I don't think that's a huge sin. All right, so I got a question from a reader. I recently left Ally bank with my emergency fund and went over to the Vanguard Tax Exempt Money Market Fund. And he asked, why did you do that? And it's basically just chasing yield. Finally, with rates coming up, the money market Funds are finally starting to pay an amount comparable to, you know, the High Yield Savings Accounts, which have been the place to keep your money for the last five, six, seven years. But if you look at the numbers and you multiply that tax exempt yield by the inverse of your marginal tax rate, it turns out that in my case, the Vanguard Tax Exempt Money Market fund, which yields 0.67% tax free, pays a little bit better than the Ally Bank High Yield Savings account that pays 1.05%. Now, 1.05 is obviously higher than 67, but once you pay the taxes on it, it's really only 0.62%, which is obviously lower than 0.67%. So it's not much of a difference. But now that the Money Market Fund is paying a little bit higher yield, I decided to move the money over there. Obviously, I already had a Vanguard account open, and so it didn't, you know, take any hassle at all other than a quick transfer over. And so that's what we're doing right now with our emergency fund is we have it in the tax exempt money market fund. This question comes. The next two questions actually come from JSmove123 on the forum. He asked a couple of questions. The first is about umbrella insurance. Who needs it? When do they need it? Why do they need it? How necessary is it? Well, umbrella insurance is personal liability coverage. Actually, it's excess personal liability coverage. Most of us have some personal liability insurance as it is both on our auto policy and on our renters or homeowners policy. If you go look at those policies, you'll realize you have some personal liability insurance on that. Now, that's not going to do you a bit of good when it comes to malpractice, but it will if somebody slips and falls on your property or if you run over somebody in the crosswalk and it was your fault, those kinds of problems, it will provide you liability coverage. So you want to make sure that those limits are high. You know, your state probably only mandates you carry limits of like $50,000 on your car, and that's not enough. It's easy to blow through $50,000 pretty quick. And so typically, I recommend that people raise their personal liability limits up to at least something like 300,000 or half a million. And then an umbrella policy stacks on top of that to give you even more personal liability coverage. And typically a doc will buy one that will raise those limits to a million or 2 million, 3 million, maybe even 5 million. Those are kind of the typical Amounts that docs carry, 1 to 5 million. And how necessary is it? Well, if you never get sued, I guess it's not necessary at all. But given that you could go broke very quickly by getting sued for something in your personal life that has nothing to do with malpractice, I think it's pretty darn necessary. The good news is it's super cheap. I think my 2 million dollar umbrella cost me like 300 bucks a year. When you compare that to my 1 million dollar malpractice policy, which cost me about 16,000 a year, that umbrella policy looks really cheap. And so I think docs need it. If you don't have one, you ought to go get one today. JS Move's second question was if physicians are considered to have a stabler or more stable income over a shorter working career than most others, how does that change their investments and their asset allocations? Should physicians take more risk and reward because of the stable higher income, or should they be more conservative because there's less need to take risk? Well, I think he outlines the two relevant considerations there. I mean the truth is a doctor doesn't have to do anything complicated with his investments in order to reach financial security. If you carve out 20% of your gross income and you save it in some reasonable way, and the easiest way is a very simple low cost mix a broadly diversified stock and bond index funds and you just put your money in there, 20% of your gross every year from now until the end of your career, you're going to have plenty of money for retirement. Doctors do not have to do anything special with their investments. All they need to do is adequately fund them and not be stupid about them. You know, that's really all there is to it. And so I think there's some truth there. Because of doctors high earnings, they can keep it very simple and don't have to take a ton of risk. But that said, a doctor's income is very stable and it's very high. There's lots of ability to take risk there. And so your asset allocation really comes down to your need and your ability and your desire to take risk. And so you're just weighing a high ability with a low need in determining what your asset allocation may end up being. Now whether that ends up being 80% stocks and 20% bonds or 50% stocks and 50% bonds, you know, really comes down to the individual. And I can't give a broad prescription for all doctors, but I can tell you my 75, 25 portfolio over the last 15 years or so has treated us very well, and we've been able to tolerate market downturns with it, and it certainly has had returns high enough for us to reach our financial goals.

Still not sure what to do with your student loans? Overwhelmed with how to tackle that giant debt in an ever changing political climate, the experts@studentloanadvice.com are here to help guide you through the best options to manage your loans. Our experienced staff have consulted on over $250 million in student loan debt and the averagestudentloanadvice.com client has saved over $190,000. You will receive a customized student loan plan using the principles of the White Coat Investor. Get answers to all of your student loan questions, gain clarity about your and start down the right path toward financial freedom. Book a consult today@studentloanadvice.com you can do this and the White Coat Investor can help.

Thanks for listening to today's episode. Head up, shoulders back. The work you do matters and you can overcome these obstacles in your financial life and reach retirement bliss. Thanks for listening. See you next time.