MythTip: Emergency fund 'smoothing'

The Business Cycle

In economics, the business cycle refers to the tendency of the conomy to fluctuate up and down from growth to recession and back again. It is a pattern that is notable throughout all of recorded economics. The economy flips back and forth, from the roaring 20′s to the Great Depression, back up in World War 2, down again in the 70′s, up again in the 60′s down again in the early 80′s, up again in the late 90′s, down in the early 21st century, up again for just a couple years, and now down again. A downturn is almost always followed by an upturn, and upturns are invariably followed by downturns. On very rare occasions (only a few times in all of history), an economy can take a downturn and never recover, leading to the destruction of the nation supported by that economy (a classic example is the fall of the Roman Empire).

The Personal Money Cycle

In like manner, our individual financial situation has a tendency to flip from prosperity to disaster and (hopefully) back again. Like economies, it is possible for our personal finances to take such a devastating downturn as to render them unable to recover. This is what insurance is for. The most catastrophic events can have their severity reduced significantly simply by purchasing proper insurance. Death of the sole bread-winner, long-term disability, and devastating medical bills are examples of the types of tragedies that can ruin our entire financial future if not properly insured against.

But what about the smaller, more routine downturns, like unexpected unemployment or an unexpected increase in living expense (like rising gas prices)? How can you be prepared for such events? There usually is no insurance that you can buy to protect you from such downturns. So what can you do?

This is where the emergency fund can form a key role in your financial peace of mind. Examine the chart below. The red line represents the financial happiness a person without an emergency fund experiences through their money; the blue represents the financial happiness a person who saves up an emergency fund when times are good. For the unprepared individual, their financial happiness tends to cycle through ups and downs. When times are good, they happily spend all that they have and really get the most out of their prosperity. But, when a tragedy strikes and suddenly they lose the prosperity they once enjoyed, anxiety and fear enter the picture. How will they pay their bills, buy groceries, make the mortgage payment? Eventually, though, the problem corrects itself (ie a new job is found) and the problems they faced begin to be corrected. eventually, they get back to living the good life, enjoying their prosperity. Until life deals them the next unexpected card and they have to endure the whole ordeal again.

Now, let’s consider the situation of an individual who has established an emergency fund. When times are good, they save some of their money. This effectively lowers the pleasure they derive from their prosperity, relative to their friends who do not have emergency savings. Their friends mock their “frugality” and urge them to increase their spending so that they can be happy. But the saver has a plan; the saver is preparing to have a happy tomorrow, not just a happy today. Before the saver know it, tragedy strikes and he suddenly finds himself without income sufficient to meet his needs. But he doesn’t sweat it because he has some savings to fall back on. So, while his friends endure the anxiety, fear, and depression of trying to pay the bills, the saver experiences very little, if any, drop in his standard of living. There is no fear for the mortgage, no creditors banging on his door and calling on his phone. He can make all his payments to everyone he owes, and can still feed his family and provide for their needs. During these periods of downturn, the saver ceases to save, he instead begins to use his savings. Then, once the crisis has passed and the saver again finds himself able to sustain himself with his income, he returns to his savings habit and replenishes his emergency fund. For the next unexpected turn is somewhere down the road, of that, he is certain.

Personal Money Cycle

A Different Timescale

As I was preparing this post, my wife made a very astute observation. Don’t we see this cycle repeating itself EVERY SINGLE MONTH for some people? When people live “paycheck-to-paycheck”, they live within a rapidly repeating version of this cycle. Each month, they get their paycheck and quickly spend it all. Once the money is gone, they enter the anxiety and fear phase. They have no money left with which to buy anything (and their credit cards may be maxed out already!), and so they live in fear of having to make an unexpected expense. But then, the next paycheck comes in and they are happy again and they go out and celebrate by spending it all. Thus the cycle perpetuates itself.

I hope that you can see how an emergency fund can alleviate most of the stress that comes when life deals us an unexpected downturn. Notice in the chart that the saver winds up in the same place as the spender, he just does so without any of the problems that come from life’s little surprises. The stability it provides can make life so much more enjoyable.

Posted on 23 Sep 2008