Questioning a financial rule of thumb

Posted by on May 26, 2009 @ 8:59 am in Personal finance

The idea that you should have a cash reserve equal to three to six months of your living expenses would almost certainly make any “Ten Commandments” list for personal finance.

It might also be one of the least obeyed commandments, as suggested in a recent post by my colleague Ellen Rinaldi. I wholeheartedly agree with Ellen’s emphasis on having a cash reserve—savings stashed in a bank account or money market fund—before getting too focused on investing.

But today’s weak economic environment has me wondering whether the “three to six months” rule of thumb is adequate. As of April 2009, the Labor Department estimated that 3.7 million Americans had been unemployed for more than six months—up from 1.4 million a year earlier.

The median duration of unemployment also rose, though far less dramatically, from 9.3 weeks in April 2008 to 12.5 weeks in April 2009 (seasonally adjusted). Even so, that means half of all people unemployed this spring had been out of work for three months or more.

Yes, some of them would have been eligible for unemployment insurance, but those benefits are likely to cover only part of a typical household’s expenses. And unemployment benefits eventually run out. I suspect that few recipients of a layoff notice feel they’ve got too much money banked for a rainy day.

So, should your emergency reserves be able to last more than six months? As with most investment or personal-finance maxims, the answer is: “It depends.”

Among the factors to consider:

• How flexible is your household budget? Some of us may have enough discretionary items in our budget to be able to dial down our spending if need be. Others have little or no leeway.

• How safe are your sources of income, whether from employment, retirement benefits, or investment income? Of the estimated 141 million people who were employed in April, it’s a safe bet that many weren’t sure whether their jobs were truly secure.

• What other resources could you tap in an emergency? Some folks plan to dip into retirement savings or draw on a home equity line of credit to keep the wolf from the door. But those are risky steps, not to be taken lightly.

The overall rise in the savings rate among households (as reported recently by the Commerce Department) suggests that a lot of us are getting serious about creating or increasing our emergency reserves. In the long run, that’s probably a good thing, because it’ll increase financial flexibility for individuals and families. It’s a glint of silver lining in the dark clouds overhanging the economy.

Notes:

• The links to BLS.gov and BEA.gov will open new browser windows. Vanguard accepts no responsibility for content on third-party sites.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

We invite your comments on this Vanguard Blog entry. Comments will be monitored and published at Vanguard’s discretion. Comments received prior to July 7, 2009 will not be published.

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