Should anyone have an emergency fund?

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nisiprius
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Should anyone have an emergency fund?

Post by nisiprius »

Austin Frakt calls my attention to a 2000 paper by one Charles B. Hatcher entitled Should Households Establish Emergency Funds? and to his his blog post about it. I wonder if he suspected it would set me off?

My reaction is: what a bunch of reckless, irresponsible hooey. The paper engages in a bunch of wild guesswork calculated to three significant digits. Austin summarizes
Even with borrowing costs as high as 18% APR (typical of some credit cards but much higher than a home equity loan) and a liquidity premium as low as 2% (well below the expected spread between equity and cash holdings) the probability of an emergency must exceed 21% to justify an EF.
There are two problems with this. The first is that I don't know my "probability of an emergency," and as nearly as I can tell neither does the author.

The first thing you need in any sane analysis is real-world data on emergencies. What sort of emergencies actually occur to real people, how often, and how much they cost. Without that data, there's just no point in doing an analysis. And I'd wager that "emergencies" are skewed and have fat tails, and that analysis should show that it takes a jillion skabillion years to gather enough data to get an accurate estimate of the kurtosis parameter.

I've lost my job twice in twenty years. If I'm reading my old statistics book correctly, that is consistent with an emergency rate of 31% per year (that is, P > 0.05 of seeing only two emergencies even though the actual rate is 31% per year).

Of course, if anyone took action based on his paper and it didn't turn out well, he could always always say it was not him, it was the reader, who made the assumptions about X.

The second big problem is the huge, huge, huge assumption that you can always get a loan when you need one. I'd be curious to know what my chances of being able to get a loan equal to six months' salary were in late 2008. That's higher than my credit card limits. I don't think there's anything close to certainty on being able to get a HELOC. Plus, the probability of to get a large loan is surely less than 100% if you have substantial debt, even if that debt is a mortgage in good standing.

Hatcher talks about silly stuff like "whether the household that saves for the event of an emergency has more net worth at the end of the life cycle." Why should anyone care about that? If the emergency hits and you don't have any cash and you can't get a loan, the negative psychological value of being up Economist's Creek without a paddle exceed the warm feelings of being able to say "But the economist assured me that the chances of that happening were small! And I take comfort that pool of grasshoppers I'm belong to will collectively have a higher net worth at the end of our life cycles then the pool of ants will!"

This sounds like the LTCM guys saying after their world crashed in ruins, "but our calculations showed that was a ten-sigma event!" It's stuff like this that makes me distrust economists.

Treating "debt" as the exact equivalent of "cash" is an example of the insanity that swept over our country during the last couple of decades. I think William J. Bernstein put it well in a different context. He was critiquing the economists' concept of "consumption smoothing" in the cases where it leads to the notion that it's fine to overspend now, because your spreadsheet predicts you'll make it up later:
Always remember Pascal's Wager: the imperative to avoid the worst-case scenario. The consequences of oversaving pale next to those of undersaving.
Last edited by nisiprius on Wed Dec 23, 2009 8:37 am, edited 2 times in total.
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Post by Bob's not my name »

On the other hand, what investments (besides real estate) are completely illiquid? I still don't understand the concept of a cash emergency fund. Why wouldn't you just liquidate your stocks, bonds, CDs, or IRAs? Other threads in this forum have argued for buying long term (vs. short term) bank CDs and paying the penalty to liquidate them if interest rates go up -- rising interest rates are hardly an emergency, so this sets the bar pretty low for willingly choosing a liquidation penalty. Other threads have argued for buying I-bonds and liquidating them early, again as a preferred vehicle vs. short term investments. Furthermore, the job loss emergency scenario does provide tax relief for the liquidation of some assets -- that is, you'd be in a lower tax bracket. I agree that a trade-off of yield loss vs. borrowing cost is not realistic, but I would be interested in an analysis of maintaining a cash emergency fund vs. less liquid investments.
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Re: Should anyone have an emergency fund?

Post by JeremiahS »

people who have lots of emergencies should hold emergency funds.
For the record how is a person expected to know this in advanced? An emergency is by it's very nature unexpected. If it wasn't it would be a planned future expense.


I'll take a paper like this seriously after he collects data on how frequently people actually have financial emergencies and then runs it through monte carlo simulations.

I like sleeping at night. I'll keep my 6 months worth of expenses earning 1.5%
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Post by nisiprius »

1)
Bob's not my name wrote:On the other hand, what investments (besides real estate) are completely illiquid?...Why wouldn't you just liquidate your stocks, bonds, CDs, or IRAs?
I agree up to a point. I think it depends on the degree of fluctuation in market value. An emergency is an emergency, but having to sell stocks when they're down 50% doubles the financial impact of the emergency. That's serious.

On my personal spreadsheet I literally have lines for three "tiers" of emergency money. I classify them a little differently due to my situation but a sensible classification would be, tier 1: true cash that can be withdrawn with no penalty; tier 2: true cash that can be withdrawn with a small penalty (CDs that unconditionally allow withdrawal before maturity, which not all do), 401(k)'s before retirement age; tier 3: assets that fluctuate less than, say, 20%, such as TIPS.


2) It occurs to me that Hatcher-style analysis could be used to make an argument against ever buying insurance. The insurance company makes a profit, so insurance never makes sense from an economist's standpoint. Why not go bare and just borrow the money to replace the car, pay the surgeon, rebuild the house when and if the need arises?

If you need to replace your house, you can just pay for it by taking out a loan on your house... can't you?
Last edited by nisiprius on Wed Dec 23, 2009 8:14 am, edited 2 times in total.
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Post by Rodc »

nisiprius wrote:It occurs to me that the same argument can be used as an argument against ever buying insurance. The insurance company makes a profit, so insurance never makes sense from an economist's standpoint. Why not go bare and just borrow the money to replace the car, pay the surgeon, rebuild the house when and if the need arises?

If you need to replace your house, you can just pay for it by taking out a loan on your house... can't you?
That was my thought as well.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
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Nobel Prize Winner Michael Spence Responds

Post by bobcat2 »

Here is what Nobel Prize Winner Michael Spence has to say about whether investors should be holding safe liquid assets as well as higher returning less liquid assets.
Investors have been hit hard by the current crisis. Lessons are being learned and investment strategies revised.

The central lesson for investors seems to me to be that not all components of risk are static, but rather evolve in ways that are not yet fully understood – and that government regulation cannot fully address. For that reason, the ability of markets to self-correct should play a role as well, which requires that investment strategies attempt to take the possibility of systemic risk into consideration.

Threats to the system as a whole can arise in a manner that is difficult to detect, and that can cause risk-mitigation strategies that work well in normal times to malfunction. Of course, major systemic disruptions do not occur every year. Instead, instability builds up until the system is shocked and resets, with the exact timing unpredictable. This means that addressing systemic risk requires a longer timeframe than that associated with the non-systemic, stationary risks to which investors devote most attention.

Consider a ten-year period and assume that there are nine years of “normal” average returns, followed by a “bad year” caused by the systemic risk component. In that case, as an example, if an investment strategy yields an 8% annual return in normal times, a large shock of 20% at ten year intervals would reduce the average 10 returns by 3.19 percentage points, to 4.81%. ...

Successful value investors may mitigate risk by shunning what they consider to be overvalued assets. Nevertheless, they are not invulnerable, because even fair valuations – or, indeed, undervaluations – are not exempt from the downward pressures of a crisis or the resetting of asset prices after a build-up of systemic risk.

Clearly, judgment is required. My preference is to assume that shocks arrive relatively frequently, but that they vary in size and probability. A sensible approach could be to hedge against intermediate-level shocks. That might also help mitigate the impact of larger shocks and increase the net return potential during severe shocks (though it might also lower the return potential for more mild shocks).

In at least one area, liquidity management, many investors learned painful lessons from the crisis. The focus has been appropriately on the cash-flow challenges that come from a combination of large illiquid investment portfolios and large systemic shocks that cause adverse shifts in the cash flow models.

But there are two other aspects of liquidity management that deserve attention. First, illiquid investments limit investors’ ability to adjust their portfolios in response to early warnings of an increase in systemic risk. Second, in times of widespread distress, liquid portfolios create investment opportunities, as depressed asset prices (often overly so) combine with the capacity to invest while others cannot or will not.

This means that liquidity has potentially significant value, which rises when systemic problems emerge. This value should be “added” to the return that is attributed to various classes of liquid assets in “normal” times, thereby affecting the relative attractiveness of liquid and illiquid assets – and influencing the asset-allocation choices made by various classes of investors.
Thus investors should hold safe low yielding but very liquid assets not just because of an emergency specific to the household, but also because of the danger of systemic financial risk in which many assets become relatively illiquid with severely depressed prices. For example, in late 2008 TIPS prices fell substantially (the yields for a while were well above 3%) and this presented a great buying opportunity. But it wasn't much of an opportunity for those who could only buy them by selling equities or REITS that had fallen 40% or more in value.

You don't want to be laid off during a financial crisis and be forced to spend out of a portfolio consisting of nearly all risk assets that have fallen substantially in value. So make sure you have enough cash or near cash safe very liquid assets (Tbills, ST Treasury fund, MMF) in reserve for emergencies specific to the household, known near term planned special expenditures, and to mitigate the general effects of a financial crisis. It's difficult to give worse advice about this than the original paper does.

Link to Michael Spence article, Investment Strategy after the Crisis.
http://www.project-syndicate.org/commen ... e6/English

In addition some posters have completely misrepresented what economics has to say about household finance. Consumption smoothing never says overspend. What it does say is to the extent possible smooth your consumption over time, i.e. plan to never overspend or underspend by any significant amount and only plan to consume out of assets outside of your reserve fund. Also it is quite possible to underspend and have catastrophic consequences. Consider the household in coastal Mississippi in 2005 who lowered spending by dropping flood insurance, or the cancer fatality who had saved substantially over the years by not getting regular physicals.

Insurance nearly always makes sense from the economist's consumption smoothing point of view, because it obviously helps smooth consumption and avoid periods of consumption disruption. Economists first want to meet future possible liabilities thru contingent claims and matching strategies including insuring, not investing and diversification strategies and self-insuring, which hold only a secondary role. That's why the theory of household economic behavior economists use, and which consumption smoothing is a part of, is called the life- cycle hypothesis of saving, investing, and insuring.

Bob K
Edited to provide link to Spence article.
Last edited by bobcat2 on Wed Dec 23, 2009 9:02 am, edited 1 time in total.
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Post by mortal »

Something occured to me last night. I went online and calculated my unemployment benefits were I to (hypothetically) lose my job. It turns out (if I ran the calculation correctly) that I could easily cover my monthly expenses. How does one factor this in when considering the size of your emergency fund?
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Post by dumbmoney »

It seems like there's an assumption that "cash" (not even paper money, but any stable value investment) has unique anti-emergency properties, compared with other equally liquid investments like stocks and bonds. People who believe that are likely to take more risk, which may be why financial advisors favor emergency funds. "Don't worry about investment risk because you'll never have to sell, thanks to your emergency fund."
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Post by Bob's not my name »

nisiprius wrote:It occurs to me that Hatcher-style analysis could be used to make an argument against ever buying insurance. The insurance company makes a profit, so insurance never makes sense from an economist's standpoint.
That's right, insurance is a rip-off. That's why very large entities self-insure for eventualities they can afford. Similarly, I believe individuals should only insure against financial catastrophes they couldn't cover -- thus, high deductible car insurance, no collision coverage on old vehicles, no life insurance on non-working spouses or children, minimal insurance on household belongings, but adequate insurance on the lives of breadwinners, adequate liability coverage on house and home. Health insurance is different because for many people it's subsidized by the government and/or their employer, so the cost/benefit trade-off is skewed.
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Post by Bob's not my name »

dumbmoney wrote:It seems like there's an assumption that "cash" (not even paper money, but any stable value investment) has unique anti-emergency properties, compared with other equally liquid investments like stocks and bonds. People who believe that are likely to take more risk, which may be why financial advisors favor emergency funds. "Don't worry about investment risk because you'll never have to sell, thanks to your emergency fund."
Excellent point.
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Post by Bob's not my name »

nisiprius wrote:having to sell stocks when they're down 50% doubles the financial impact of the emergency
Eh, how do you know when stocks are "down 50%"? That's a sunk cost argument. Moreover, bobcat's post argues for market timing as well. I don't necessarily disagree -- the markets always overreact, and I thought it was obvious this past spring that we had a buyer's market. Nonetheless, this is not bogleheaded, right?

One more point: I bet at least some of the people who argue that it's ok to hold stock in your own employer also advocate holding a cash emergency fund. Collapse of your employer's stock and loss of your job are not uncorrelated probabilities. A better emergency plan is not to compound your risks.

Addendum -- Loss of employment and a general down market are somewhat correlated probabilities, so stocks make a bad emergency fund if the emergency you're primarily concerned about is loss of employment. In other words, I'm persuaded by your argument about stocks being down 50% doubling the impact of the emergency.
Last edited by Bob's not my name on Wed Dec 23, 2009 9:57 am, edited 1 time in total.
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Post by S&L1940 »

mortal wrote:Something occured to me last night. I went online and calculated my unemployment benefits were I to (hypothetically) lose my job. It turns out (if I ran the calculation correctly) that I could easily cover my monthly expenses. How does one factor this in when considering the size of your emergency fund?
it is obvious you do not live in Florida

or, you have really low overhead and living expenses

Happy Holidays Rich
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Re: Should anyone have an emergency fund?

Post by alec »

nisiprius wrote:Treating "debt" as the exact equivalent of "cash" is an example of the insanity that swept over our country during the last couple of decades. I think William J. Bernstein put it well in a different context. He was critiquing the economists' concept of "consumption smoothing" in the cases where it leads to the notion that it's fine to overspend now, because your spreadsheet predicts you'll make it up later:
Always remember Pascal's Wager: the imperative to avoid the worst-case scenario. The consequences of oversaving pale next to those of undersaving.
So, I shouldn't borrow money to go to college?
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Post by Valuethinker »

Bob's not my name wrote:
nisiprius wrote:It occurs to me that Hatcher-style analysis could be used to make an argument against ever buying insurance. The insurance company makes a profit, so insurance never makes sense from an economist's standpoint.
That's right, insurance is a rip-off. That's why very large entities self-insure for eventualities they can afford. Similarly, I believe individuals should only insure against financial catastrophes they couldn't cover -- thus, high deductible car insurance, no collision coverage on old vehicles, no life insurance on non-working spouses or children, minimal insurance on household belongings, but adequate insurance on the lives of breadwinners, adequate liability coverage on house and home. Health insurance is different because for many people it's subsidized by the government and/or their employer, so the cost/benefit trade-off is skewed.
Yes the US tax system subsidizes employer-sponsored health insurance.

It's not at all clear, however, that moral hazard purveys in health insurance. Quite the opposite, from the data.

Generally in insurance the market works against you. It's hard to buy high deductible coverage (I went through this in the UK, at least-- you cannot really buy high excess policies) and protection against true catastrophe is difficult (exclusions for floods, terrorism etc. are common).

The form of self insurance most of us probably practice is a standard policy BUT we don't claim for small losses, because the impact on your renewal rate is too high (loss of no claims bonus).
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Post by Valuethinker »

mortal wrote:Something occured to me last night. I went online and calculated my unemployment benefits were I to (hypothetically) lose my job. It turns out (if I ran the calculation correctly) that I could easily cover my monthly expenses. How does one factor this in when considering the size of your emergency fund?
You need probability of getting that insurance paid, and probability of being out of a job for longer than insurance runs.

I would suggest it shouldn't alter your investment plans a jot, nor cause you to lower your emergency reserve. I'd take UI as 'bunce' as they say in Yorkshire ie unplanned upside.
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Re: Should anyone have an emergency fund?

Post by Valuethinker »

nisiprius wrote:Austin Frakt calls my attention to a 2000 paper by one Charles B. Hatcher entitled Should Households Establish Emergency Funds? and to his his blog post about it. I wonder if he suspected it would set me off?

My reaction is: what a bunch of reckless, irresponsible hooey. The paper engages in a bunch of wild guesswork calculated to three significant digits. Austin summarizes
Even with borrowing costs as high as 18% APR (typical of some credit cards but much higher than a home equity loan) and a liquidity premium as low as 2% (well below the expected spread between equity and cash holdings) the probability of an emergency must exceed 21% to justify an EF.
There are two problems with this. The first is that I don't know my "probability of an emergency," and as nearly as I can tell neither does the author.

The first thing you need in any sane analysis is real-world data on emergencies. What sort of emergencies actually occur to real people, how often, and how much they cost. Without that data, there's just no point in doing an analysis. And I'd wager that "emergencies" are skewed and have fat tails, and that analysis should show that it takes a jillion skabillion years to gather enough data to get an accurate estimate of the kurtosis parameter.

I've lost my job twice in twenty years. If I'm reading my old statistics book correctly, that is consistent with an emergency rate of 31% per year (that is, P > 0.05 of seeing only two emergencies even though the actual rate is 31% per year).

Of course, if anyone took action based on his paper and it didn't turn out well, he could always always say it was not him, it was the reader, who made the assumptions about X.

The second big problem is the huge, huge, huge assumption that you can always get a loan when you need one. I'd be curious to know what my chances of being able to get a loan equal to six months' salary were in late 2008. That's higher than my credit card limits. I don't think there's anything close to certainty on being able to get a HELOC. Plus, the probability of to get a large loan is surely less than 100% if you have substantial debt, even if that debt is a mortgage in good standing.

Hatcher talks about silly stuff like "whether the household that saves for the event of an emergency has more net worth at the end of the life cycle." Why should anyone care about that? If the emergency hits and you don't have any cash and you can't get a loan, the negative psychological value of being up Economist's Creek without a paddle exceed the warm feelings of being able to say "But the economist assured me that the chances of that happening were small! And I take comfort that pool of grasshoppers I'm belong to will collectively have a higher net worth at the end of our life cycles then the pool of ants will!"

This sounds like the LTCM guys saying after their world crashed in ruins, "but our calculations showed that was a ten-sigma event!" It's stuff like this that makes me distrust economists.

Treating "debt" as the exact equivalent of "cash" is an example of the insanity that swept over our country during the last couple of decades. I think William J. Bernstein put it well in a different context. He was critiquing the economists' concept of "consumption smoothing" in the cases where it leads to the notion that it's fine to overspend now, because your spreadsheet predicts you'll make it up later:
Always remember Pascal's Wager: the imperative to avoid the worst-case scenario. The consequences of oversaving pale next to those of undersaving.
1. the assumption of liquidity and open credit markets is common in economics, and during the credit crunch, totally wrong.

2. I don't find probability that useful when talking about personal catastrophes.

I either get cancer, or not. And I am either cured, or not.

In a sense, for me, those are both 100% probabilities or 0%. I care about the outcome NOT about the ex ante probability.
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Post by mortal »

It seems I miss-calculated. For some reason I forgot that unemployment benefits vary from state to state. Apparently alabama is a bit less generous than I thought. I could (barely) get by on the maximum benefit, but I'd still want a 6 mo emergency fund.
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Post by natureexplorer »

nisiprius wrote:On my personal spreadsheet I literally have lines for three "tiers" of emergency money. I classify them a little differently due to my situation but a sensible classification would be, tier 1: true cash that can be withdrawn with no penalty; tier 2: true cash that can be withdrawn with a small penalty (CDs that unconditionally allow withdrawal before maturity, which not all do), 401(k)'s before retirement age; tier 3: assets that fluctuate less than, say, 20%, such as TIPS.
Wouldn't this mean that you'd be changing your asset allocation to a riskier one at a time you might be the least comfortable with it? So in essence you'd still have to sell stocks just to get your asset allocation back on target? This is of course unless you do not consider any of the above mentioned investments as part of your AA.
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Re: Should anyone have an emergency fund?

Post by Finder »

nisiprius wrote:
My reaction is: what a bunch of reckless, irresponsible hooey. The paper engages in a bunch of wild guesswork calculated to three significant digits. Austin summarizes
Even with borrowing costs as high as 18% APR (typical of some credit cards but much higher than a home equity loan) and a liquidity premium as low as 2% (well below the expected spread between equity and cash holdings) the probability of an emergency must exceed 21% to justify an EF.
There are two problems with this. The first is that I don't know my "probability of an emergency," and as nearly as I can tell neither does the author.
.
I believe this economist is seeing the forest but not the trees. Even if in the aggregate it may be reasonable for an economy to behave in such a way, for individuals it could pose incredible hardships. For some of those hardships there is insurance available, for others only personal assets will do. Amazing he would be so disconnected of potential catastrophic events on individuals, seems to me a very dangerous approach and intellectually irresponsible.

Emergency funds I believe are necessary by definition since an emergency could happen to anyone. In what asset classes they are held may depend on the level of assets individuals possess and the effect an emergency would have on that level of assets, taking into account potential volatility of investments happening concurrently.

For an individual with very large assets, he may only need a proportionally very small level of very liquid, less volatile assets as part of their allocation. Their "emergency fund" may be effectively that amount plus maybe a little more out of other more volatile asset classes. If the emergency hits, this individual could use his cash plus a small portion of his other assets, and regardless of market swings this would not significantly affect his overall level of assets. So technically no separate "emergency fund" is actually needed, this individual does not need to worry about this issue when dealing with his asset allocation. This individual would be able to respond to an emergency thanks to his large assets and proportionally small effect the emergency would have on his level of assets compared to the volatility of the markets. The markets could move his assets by 20 to 40 percent at any one time but if the emergency can only hit him with 1% effect for example, then he is under less need to worry about structuring a separate emergency fund.

An individual with less of a portfolio I believe would need to be more prescriptive in having a set "emergency fund" in very liquid/non volatile assets such as cash, then CDs etc. This because if an emergency were to hit this individual and he were only invested in higher risk instruments and at the same time he were hit with a rapidly declining/down market he would be drawing much higher percentages of his overall portfolio due to the emergency. As an example, if the market could move his assets by 20 to 40 percent but an emergency can affect his assets by 5 to 15 percent or more then this individual should probably try to structure an emergency fund, maybe in layers of cash, CDs, etc.

In other words I believe the size and composition of an "emergency fund" needs to take into account the volatility to the overall portfolio size that withdrawing unexpected chunks of assets would create in the portfolio and that happening potentially at the same time of a market downturn.

Since by definition the majority of investors don't have a very large level of assets compared with the negative effects of an emergency or series of them, I believe the most sensible approach is for most to have an emergency fund. Seems all comes back to volatility and risk. As the level of assets increases the need for a separate "emergency fund" decreases.
But in the end a personal decision.
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Post by sewall »

The real question I have is how large should one's emergency fund be. I've yet to see any credible basis for typical answers. I can imagine studies that would convince me but I'm not aware of them.

Hatcher's was the first I've seen that approached the EF issue with anything like a rational basis. One can actually use his approach to get a handle on how big an EF one needs. Take the specific example in the paper and post, in which the borrowing cost is 18% APR and liquidity premium is 2%. With those assumptions, the probability of an emergency must exceed 21% to justify an EF.

But you can turn this around and ask, what size emergency is likely to occur more frequently than ~1 in 5 years? Nobody knows the answer to this for him/herself exactly, but it is a nice way to frame the problem of EF size determination.

Since EF size is largely a guess, why not guess on this basis, or at least consider it?

I feel that if I take this approach seriously (and if I believed the borrowing costs and liquidity premiums as given above), I'd probably hold an EF that is half what I do. If that is the case, what's the other half for?

Two answers: (1) to hedge against the possibility that my assumptions are wrong and (2) because I'm irrationally conservative.

I'm comfortable living with those two answers. In particular, there is no requirement that one set an EF size rationally. But I think there is value in understanding that to be the case. One can do things rationally (or more rationally). It is possible. But it my not feel right or be convincing for extra-rational reasons. And there's nothing wrong with that. I just happen not to be satisfied with it for intellectual reasons.
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Re: Should anyone have an emergency fund?

Post by Wagnerjb »

nisiprius wrote: My reaction is: what a bunch of reckless, irresponsible hooey. The paper engages in a bunch of wild guesswork calculated to three significant digits. Austin summarizes
Even with borrowing costs as high as 18% APR (typical of some credit cards but much higher than a home equity loan) and a liquidity premium as low as 2% (well below the expected spread between equity and cash holdings) the probability of an emergency must exceed 21% to justify an EF.
There are two problems with this. The first is that I don't know my "probability of an emergency," and as nearly as I can tell neither does the author.
This is a very sensible economic analysis. The author is saying that a 21% probability of an emergency may be the cut-off point. You don't need to know the exact probability of an emergency. Just whether you feel it is higher or lower than 21%.

We make economic decisions using similar analysis all the time. For example, when you evaluate whether to invest in the Tax Managed fund, you are afraid of paying the 2% fee for selling the fund within 5 years. So you run the numbers, thinking...."if the probability of selling the fund within 5 years is less than xx%, I am better off using this fund for the tax benefits".
The second big problem is the huge, huge, huge assumption that you can always get a loan when you need one. I'd be curious to know what my chances of being able to get a loan equal to six months' salary were in late 2008.
The author specifically says, "The results are meaningless if households cannot borrow for some reason." So, if that applies to you, just ignore the study.
I don't think there's anything close to certainty on being able to get a HELOC. Plus, the probability of to get a large loan is surely less than 100% if you have substantial debt, even if that debt is a mortgage in good standing.
Don't forget that you can "borrow" from your 401K (unless the emergency is loss of your job).

Best wishes.
Andy
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Post by Levett »

Bob K--

Thanks for posting the Spence piece.

I've lived long enough (and through enough) to see what good sense it makes. Bob U.
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Post by segfault »

mortal wrote:Something occured to me last night. I went online and calculated my unemployment benefits were I to (hypothetically) lose my job. It turns out (if I ran the calculation correctly) that I could easily cover my monthly expenses. How does one factor this in when considering the size of your emergency fund?
Your unemployment benefits will be denied if your former employer can prove you were fired for cause, or if you were forced to resign "voluntarily."
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Post by jeffarvon »

mortal wrote:
Something occurred to me last night. I went online and calculated my unemployment benefits were I to (hypothetically) lose my job. It turns out (if I ran the calculation correctly) that I could easily cover my monthly expenses. How does one factor this in when considering the size of your emergency fund?
Keep in mind there are cases if you are fired (as opposed to being laid-off) you are ineligible for unemployment benefits.

I was heartened to see the update
... but I'd still want a 6 mo emergency fund.
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Re: Nobel Prize Winner Michael Spence Responds

Post by Kenkat »

bobcat2 wrote:Thus investors should hold safe low yielding but very liquid assets not just because of an emergency specific to the household, but also because of the danger of systemic financial risk in which many assets become relatively illiquid with severely depressed prices. For example, in late 2008 TIPS prices fell substantially (the yields for a while were well above 3%) and this presented a great buying opportunity. But it wasn't much of an opportunity for those who could only buy them by selling equities or REITS that had fallen 40% or more in value.

You don't want to be laid off during a financial crisis and be forced to spend out of a portfolio consisting of nearly all risk assets that have fallen substantially in value. So make sure you have enough cash or near cash safe very liquid assets (Tbills, ST Treasury fund, MMF) in reserve for emergencies specific to the household, known near term planned special expenditures, and to mitigate the general effects of a financial crisis. It's difficult to give worse advice about this than the original paper does.
I think this is an excellent argument as to why most need some form of emergency fund.

I do think it is a good idea to only hold a portion of one's emergency fund in cash and to hold the additional portion in short or intermediate term bonds or other "semi-stable" investment. And perhaps even a third tier in more risky investments such as stocks, lines of credit available to tap, 401k plans accessible via loans, etc. Things you'd never want to use but could if absolutely necessary.

Many will never need to tap the emergency fund, so from that perspective, it doesn't make sense to let it all languish in cash.

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Post by nisiprius »

sewall wrote:The real question I have is how large should one's emergency fund be. I've yet to see any credible basis for typical answers.
I think the typical answers are based on

a) intuition about the probability distributions of emergencies and
b) intuition about emergency fund size given that probability distribution,

And the problem is not that b) is based on intuition rather than calculation. The problem is lack of data about a).

The Hatcher paper says "if we had ham, we could have ham and eggs--if we had some eggs." But we don't have the ham.

Finally, we need to account for what what Bernstein calls "Pascal's wager." In this context the consequences of too large an emergency fund are that the household has "a lower net worth at the end of the life cycle," while the consequences of too low an emergency fund can be anywhere from disruptive to catastrophic.
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Re: Should anyone have an emergency fund?

Post by nisiprius »

Wagnerjb wrote:This is a very sensible economic analysis. The author is saying that a 21% probability of an emergency may be the cut-off point. You don't need to know the exact probability of an emergency. Just whether you feel it is higher or lower than 21%.
I have no way to know whether it is higher or lower than 21%. OK, I'll play the game: yes, I think it's higher than 0.01%, and yes, I think it's lower than 50%. Does that tell me anything useful about what my emergency fund should be?

But I'm probably wrong even about that, because of all the studies that show that people are consistently overconfident about the accuracy of their estimates, and that furthermore even when people are asked to make an estimate and state a range, they usually state too narrow a range and the real answer falls outside it.

Economists and financial advisors lead people into that trap all the time: they put the onus on you by saying "if you think X then..." and the very fact that they are asking you makes you feel that you ought to know, and engages the part of your brain that sees faces in rock formations. When someone asks you for your prediction, it's irresistible to make one, and once you make one you believe it, and then if it goes wrong they blame you instead of the person who egged you into making it.
The second big problem is the huge, huge, huge assumption that you can always get a loan when you need one.
The author specifically says, "The results are meaningless if households cannot borrow for some reason." So, if that applies to you, just ignore the study.
I have no way of knowing whether that applies to me until I need the loan and apply for it. Just because the local bank used to deluge me with invitations to take out a HELOC doesn't mean they'd have given me one late last year.
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Post by jenbcapecod »

This is what works for me -

I have a couple of emergency funds.

A very liquid easily-accessible small fund with one-month's expenses; and another that can be tapped if necessary that is not so liquid. The first fund is for things like - my car transmission blowing up; or my dishwashing breaking for the last time.

For the long term, you have to factor in the volatility of your living situation (I think) such as:

who depends upon you and for how much?
if you are working, how stable is (your job, your industry)?
your age
how much you already have saved[/list]
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Re: Nobel Prize Winner Michael Spence Responds

Post by Wagnerjb »

bobcat2 wrote:Thus investors should hold safe low yielding but very liquid assets not just because of an emergency specific to the household, but also because of the danger of systemic financial risk in which many assets become relatively illiquid with severely depressed prices.
Bob - Larry Swedroe has done an excellent job of explaining clearly and coherently why investors should stick to short-term and safe investments on the fixed income side. And I agree with the logic. I also agree with your emphasis on holding short-term and safe fixed income, but it has nothing to do with emergency funds. The author's arguments for skipping an emergency fund revolve around your ability to borrow....not your ability to access long-term savings.
For example, in late 2008 TIPS prices fell substantially (the yields for a while were well above 3%) and this presented a great buying opportunity. But it wasn't much of an opportunity for those who could only buy them by selling equities or REITS that had fallen 40% or more in value.
Again, this has nothing to do with an emergency fund. Are you gonna decimate your emergency fund - which you presumably need - just to take advantage of some perceived mispricing? I sure hope not.

And are you going to sell equities (when they are depressed) to add to your bond holdings? That is exactly the opposite of what to do. You would be selling fixed income to buy equities when stocks are down.

However, disciplined Bogleheads can - and presumably did - take advantage of the TIPs decline. They keep half of fixed income in regular Treasuries and half in TIPs. A year ago, they were selling regular Treasuries and buying equities in a rebalancing move. If they wanted to roll the dice on TIPs, they would have shifted some regular Treasuries to TIPs....all the time keeping their fixed income balance at the appropriate AA level. They would not have drained their emergency fund to do this.

Best wishes.
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Re: Should anyone have an emergency fund?

Post by sewall »

nisiprius wrote:I have no way to know whether it is higher or lower than 21%. OK, I'll play the game: yes, I think it's higher than 0.01%, and yes, I think it's lower than 50%. Does that tell me anything useful about what my emergency fund should be?
Look at it this way. We all make some guess about our EF. From that guess and some assumptions (which you can vary over a reasonable range if you like) you can compute the rate of emergencies for which that EF size would be rational. That exercise alone may help someone think through whether the EF size seems right.

I think many folks tend to get hung up on the use of the word "rational" or just the use of assumptions + math to arrive at an answer, as if it means that's the right answer. All it is is a formal way of thinking that helps folks who are so inclined to organize their thoughts.

I'm of the type that finds thinking thing things through in such formal ways to be of help in being very clear about what are assumptions, what are goals, and how the two fit together. For a long time I have not understood how one could arrive at a sensible EF size, even in principle. This is one way, and with some supporting studies I could imagine it being quite a good way. If one is sensible about the range over which assumptions can vary, how could it be worse than a guess? (Yes if one uses it stupidly then it is worse than a guess. But only a stupid person would do that and a stupid person might have made a stupid guess anyway.)
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Post by Rodc »

However, disciplined Bogleheads can - and presumably did - take advantage of the TIPs decline. They keep half of fixed income in regular Treasuries and half in TIPs. A year ago, they were selling regular Treasuries and buying equities in a rebalancing move. If they wanted to roll the dice on TIPs, they would have shifted some regular Treasuries to TIPs....all the time keeping their fixed income balance at the appropriate AA level. They would not have drained their emergency fund to do this.
That is exactly what I did.

Then as stocks rose and TIPS yields declined, I rebalanced using new money (and sold some stocks along the way) into nominal Treasuries.

I also decided to beef up our emergency funds a bit and added some extra there.

Seemed like the thing to do. I'm still over weight in TIPS, but they are doing fine and over time I'm on track to even out TIPS/nominals.
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Post by Jack »

mortal wrote:Something occured to me last night. I went online and calculated my unemployment benefits were I to (hypothetically) lose my job. It turns out (if I ran the calculation correctly) that I could easily cover my monthly expenses. How does one factor this in when considering the size of your emergency fund?
There are a lot more possible emergencies than just a job layoff. What if you become ill or have a car accident and cannot work? Or your spouse becomes ill and the children require daycare? Sorry, no unemployment benefits for you. You are on your own.
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Post by Wagnerjb »

Rodc wrote:
However, disciplined Bogleheads can - and presumably did - take advantage of the TIPs decline. They keep half of fixed income in regular Treasuries and half in TIPs. A year ago, they were selling regular Treasuries and buying equities in a rebalancing move. If they wanted to roll the dice on TIPs, they would have shifted some regular Treasuries to TIPs....all the time keeping their fixed income balance at the appropriate AA level. They would not have drained their emergency fund to do this.
That is exactly what I did.

Then as stocks rose and TIPS yields declined, I rebalanced using new money (and sold some stocks along the way) into nominal Treasuries.
Same here :D
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Post by bobcat2 »

Hi Andy,

I believe the size of the reserve fund should be big enough to handle a household emergency during a financial crisis. For a multitude of reasons, including those stated by Nobel Laureate Michael Spence, I think it makes sense to hold a reasonable amount of assets in both taxable and tax advantaged accounts that are nominal very high quality and of short duration. IMO, a big problem with the original paper, which Spence points out, is that during periods of financial crisis liquidity may dry up and you won’t be able to borrow.

In the fall of 2008 if you were buying TIPS with nominal ST Treasuries you were deliberately keeping FI higher than it was before the crisis, thanks to Mr. Market hammering stocks. And you would have had very good reasons for doing so. Thus, I fail to see how buying TIPS at real yields of 3.3% with nominal ST Treasuries is “rolling the die”. On the other hand, if you were buying equities a year ago by selling nominal ST Treasuries, it seems to me you were “rolling the die”.

I also see no good rational for FI to be 50/50 (nominal/real), or what Bodie calls naive bond diversification. Overall, it seems to me, FI should be mainly used for matching strategies and the percentage of nominal vs. real should depend on how much of your liabilities are nominal and how much are real, as long as the nominal ST high quality FI part covers your reserve fund target size. For most households the majority of future expected liabilities is future consumption and would therefore be real, rather than nominal.

Best,
Bob K
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Post by VictoriaF »

bobcat2 wrote:I also see no good rational for FI to be 50/50 nominal/real, or what Bodie calls naive bond diversification. Overall, it seems to me, FI should be mainly used for matching strategies and the percentage of nominal vs. real should depend on how much of your liabilities are nominal and how much are real, as long as the nominal ST high quality FI part covers your reserve fund target size. For most households the majority of future expected liabilities is future consumption and would therefore be real, rather than nominal.

Best,
Bob K
Hi Bob,

This is slightly off topic, but my fixed income (FI) is 50/50, where the TSP G-fund is the nominal half. Would you consider that "naive"?

Thanks,
Victoria
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Post by Rodc »

Bodie calls naive bond diversification
Sticks and stones and all that. :P

I have something of a TIPS ladder started, but given the gaps in availability, and given I don't really know what future expenses will be needed when (when will I need to buy a car decades from now, when will I decide to move into a CCRC, will I decided to move into a CCRC, etc.) I can't do all that good a job of matching future needs to particular TIPS.

So be it if it is naive, I don't know which will do best over time, TIPS or nominals. Nor do I know which will be best, stocks or bonds, US or International.

So (somewhat) naive diversification seems perfectly rational to me, be it bonds or stocks. :)

And thus when I tilted TIPS in my FI, I for the first time in many years varied from my stated plan, and thus rolled the die, if you will: I bet my money that this was a particularly good time to buy TIPS and not such a good time to buy nominal. Not a particularly risky or wild bet as bets go, I admit.
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Post by Triple digit golfer »

In my opinion a cash cushion is absolutely necessary. I couldn't sleep at night knowing that if I lost my job tomorrow I'd have no money for food by the end of next week.

Sure, you could cash out investments, maybe get a loan, sell your car, go to a pawn shop, beg on the street, or any number of things, but I think having some cash to fall back on is a heck of a lot better than those options. A cash cushion allows breathing room. "OK, I lost my job, but I can survive just fine for (insert number of months here) months." This allows you to concentrate on what really matters: finding another job, rather than figuring out how you're going to pay for food or rent.

The same goes for some other emergency other than job loss. Kid in jail, needs $20,000 to be bailed out (luckily my parents only needed $100 when I was in).
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Post by bobcat2 »

Hi Victoria,

The G fund is quasi inflation protected due to its unique structure. Also, many people including I'll bet you, are constrained by how much TIPS assets they can own. Heather, for example, has a lot bigger percentage of her portfolio in the G fund rather than in a TIPS fund or individual TIPS. She would like to own more TIPS or more in a TIPS fund, but the TSP constrains her ability to hold more. Luckily the G fund is a mighty fine substitute.

The naive diversification Bodie is talking about is when 'experts' advise 50/50 (nominal/real) bond holdings when the investor is not constrained by how much of either nominal or real fixed income she can hold.

Here's Bodie addressing this issue earlier this year.
Bodie doesn't believe in a 50/50 approach between inflation-linked bonds and regular or nominal bonds. He sees no point in taking inflation risk with regular bonds. "Why take that risk? it's not like nominal bonds offer a risk premium the way equities do." ...

He points me to this chart on his web site (or click on Market Indicators). There you'll see the 20-year rate on nominal U.S. bonds is 4.51%, compared to 2.3% for TIPs. "So what that says in my judgement is it's crazy to invest now in 20-year nominal bonds. It's incredibly risky because we don't know what inflation is going to be."...

So the net is that even though he doesn't worry about Zimbabwe style hyperinflation, Bodie does believe in TIPs and RRBs. Either is a safe investment no matter what inflation turns out to be: "it's a long run hedge against inflation."

By contrast, you can get 4.51% with nominal bonds but you're totally exposed to inflation risk if it turns out inflation exceeds the breakeven rate of roughly 2.2%. "Then I'm behind the 8-ball relative to my safe real rate of return. So I ask you, do you think it's out of the question that inflation will exceed 2.2%?"

I answer "Sure, it probably will run past 2.2% in a few years."

"I think it's probable," Bodie agrees, "That's my point. You don't have to have a lot of inflation for me to view nominal bonds as risky."

50/50 split of nominal vs TIPs "naive diversification"

So why not split your fixed income allocation 50/50 between nominal bonds and inflation bonds?, I ask.

"That's naive diversification," he retorts. Investors need to first make a distinction between assets they know to be safe and those that are risky. If you don't want to take any chances, you put most of your money in the safe asset,...With that base in place, you can then proceed and say "How does the picture change if I take some risk?"...

We shift the conversation to his book (Worry-Free Investing), which he says has sold 10,000 copies. That's not bad but it could be a lot better. I infer that the financial services industry may not be anxious for it to succeed, given that most financial advisors embrace the equity culture.

"Correct," Bodie repies, "They want to sell more books like Stocks for the Long Run. How can investment advisors and the investment industry make money if books like these suggest government bonds?":D


Link to article.
http://network.nationalpost.com/np/blog ... rview.aspx

Happy Holidays V.,

Bob K
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Post by LadyGeek »

Sorry, I just could not disagree more with that paper.

My fundamental problem is the use of periodic assumptions when the emergency occurs. If it's before Dec 31, do this. Otherwise, after Jan 1, do a different thing. That's not an emergency fund.

An emergency fund should be synced with the time between occurrence and funds required.

For example, my sewer line broke last month (I'll spare the details, the joys of a homeowner...).
Needed immediately - $300 to clear the line (temporary fix)
Needed in 4 days - $2.5k to replace the house trap in the line (the problem)

My former(!) financial advisor suggested a way to bucket the emergency funds, which makes sense to me:

10% to your local brick-n-mortar bank for same day availability. This is your ATM card linked to a checking or savings account. The lowest interest, but quickest access when you need it.

40% to a savings account that's at a slightly higher interest rate, but 2 - 3 day delay to get your money. For example, ING.

50% to the long-term savings. CDs, IRAs, etc. go here. For emergencies in this category, it's usually pretty serious and you have some time to plan. Job layoff, etc.

Which brings me back to the original question- how much of a buffer ("cushion") do you need? For a homeowner, automobile owner, you need some data points. This year, it was my house. Last year, it was car tires.

I still think that 6 months (or more) living expenses, no matter what you call it, is a good number to use. It's where you put it that also matters.

Planning for a home addition or buying a new TV is not an emergency fund. Those are discretionary expenses budgeted separately.
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Post by Triple digit golfer »

LadyGeek,

With all due respect, how is a new TV any less of an emergency than car tires? Didn't you know you'd need them?
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Post by alec »

LadyGeek wrote:Which brings me back to the original question- how much of a buffer ("cushion") do you need?
I think this is a "you won't know until it happens" situation. :wink:
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Post by VictoriaF »

bobcat2 wrote:...

Happy Holidays V.,

Bob K
Thank you, Bob,

Happy Holidays to you, too,

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Post by LadyGeek »

Triple digit golfer wrote:LadyGeek,

With all due respect, how is a new TV any less of an emergency than car tires? Didn't you know you'd need them?
My car tire "emergency" was caused by a fireplace log that was sitting in the left lane of the PA turnpike. Took out a wheel and 2 tires (not repairable). The aluminum wheel was $500+, not to mention performance tires. Probably better categorized as automotive incident, not maintenance. My insurance policy has no deductible for glass, so windshield replacements are no cost (again, thanks to the PA turnpike- twice+). Different commute this year, fortunately.

My 67" TV failed earlier this year. Not worth repair. I needed to replace it with equal or better picture quality. This could probably be in the "urgent" category, not quite emergency. One more point - lifestyle choices can influence what constitutes an emergency. High-Def TV is important to me (note my avatar is a TV test pattern). If I really could not afford it, I'd do something else.

As alec says - you don't know what you need until something happens. My database is getting filled with "things that happened".

Happy Holidays to all. :)
Last edited by LadyGeek on Wed Dec 23, 2009 8:59 pm, edited 1 time in total.
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Post by joe8d »

In my opinion a cash cushion is absolutely necessary. I couldn't sleep at night knowing that if I lost my job tomorrow I'd have no money for food by the end of next week.

Sure, you could cash out investments, maybe get a loan, sell your car, go to a pawn shop, beg on the street, or any number of things, but I think having some cash to fall back on is a heck of a lot better than those options. A cash cushion allows breathing room. "OK, I lost my job, but I can survive just fine for (insert number of months here) months." This allows you to concentrate on what really matters: finding another job, rather than figuring out how you're going to pay for food or rent.

The same goes for some other emergency other than job loss. Kid in jail, needs $20,000 to be bailed out (luckily my parents only needed $100 when I was in).
I agree. I've aways had " Savings" or accessible Cash Reserves to cover:
(1) Current expenses
(2) Anticipated future expenses
(3) Unanticipated expenses (emergencies)

and insurance for catastrophic events.
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Post by Sonoran »

Something occured to me last night. I went online and calculated my unemployment benefits were I to (hypothetically) lose my job. It turns out (if I ran the calculation correctly) that I could easily cover my monthly expenses. How does one factor this in when considering the size of your emergency fund?
I wouldn't factor it in at all. I usually assume worst-case scenario with zero income.
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Post by Rodc »

There you'll see the 20-year rate on nominal U.S. bonds is 4.51%, compared to 2.3% for TIPs. "So what that says in my judgement is it's crazy to invest now in 20-year nominal bonds. It's incredibly risky because we don't know what inflation is going to be."...
If we don't know what inflation is going to be, how can we know if the spread is in favor or nominal or in favor of TIPS? Sounds like a judgement call.

Oh wait, I forgot, he said it was a judgment call. :P

This is really a lot like (maybe exactly like) market timing, assuming you know more than the market.

My expectation is that over time, averaged and all, TIPS will tend to have a lower return than nominals because I agree, they are less risky.

I might also add he set up a false dichotomy. I certainly do not take my only two choices as TIPS or 20-year nominals. Truth be told I too think buying 20-year nominal is a lousy bet and so I skip that choice. But that is not my only choice in nominals.
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Post by Triple digit golfer »

LadyGeek wrote:
Triple digit golfer wrote:LadyGeek,

With all due respect, how is a new TV any less of an emergency than car tires? Didn't you know you'd need them?
My car tire "emergency" was caused by a fireplace log that was sitting in the left lane of the PA turnpike. Took out a wheel and 2 tires (not repairable). The aluminum wheel was $500+, not to mention performance tires. Probably better categorized as automotive incident, not maintenance. My insurance policy has no deductible for glass, so windshield replacements are no cost (again, thanks to the PA turnpike- twice+). Different commute this year, fortunately.

My 67" TV failed earlier this year. Not worth repair. I needed to replace it with equal or better picture quality. This could probably be in the "urgent" category, not quite emergency. One more point - lifestyle choices can influence what constitutes an emergency. High-Def TV is important to me (note my avatar is a TV test pattern). If I really could not afford it, I'd do something else.

As alec says - you don't know what you need until something happens. My database is getting filled with "things that happened".

Happy Holidays to all. :)
Ah, I see. So it wasn't just routine new tires. You had an incident. That makes sense now.
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Post by Bob's not my name »

Still not getting it. 6 months' expenses = $60,000. New tires $600. Not an emergency.

Loss of income would be an emergency. If you're self-employed you might need a big emergency fund. If you work for a large employer you should have significant buffers against loss of income: accumulated vacation, disability coverage, severance. If you're in a high effective tax bracket (>40% federal + state), a loss of gross income yields a relatively modest loss of net income. If you have kids in college, they'll get aid. Including financial aid effects, it's possible for a middle class family to have an effective tax rate of 80%. If you're unemployed for a brief period, the impact can actually be small. If you're unemployed for a long time, you can draw from your investments in a planned manner, to minimize tax and volatility effects. It's a terrible thing to go through, but I'm still not getting why you need to consider a (huge) emergency fund as a fenced off part of your portfolio, unless you have a really high risk portfolio.
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Post by james22 »

Depends too one one's monthly investment savings and discretionary income, I'd think. Can always credit card emergencies to that amount without cost.
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Post by spam »

Bob's not my name wrote:On the other hand, what investments (besides real estate) are completely illiquid? I still don't understand the concept of a cash emergency fund. Why wouldn't you just liquidate your stocks, bonds, CDs, or IRAs? Other threads in this forum have argued for buying long term (vs. short term) bank CDs and paying the penalty to liquidate them if interest rates go up -- rising interest rates are hardly an emergency, so this sets the bar pretty low for willingly choosing a liquidation penalty. Other threads have argued for buying I-bonds and liquidating them early, again as a preferred vehicle vs. short term investments. Furthermore, the job loss emergency scenario does provide tax relief for the liquidation of some assets -- that is, you'd be in a lower tax bracket. I agree that a trade-off of yield loss vs. borrowing cost is not realistic, but I would be interested in an analysis of maintaining a cash emergency fund vs. less liquid investments.
Hi Bob,

a small emergency just presented itself at my door at 7:45 am. (no kidding) Please ignore this post as I dont have time to respond.

spam
Last edited by spam on Thu Dec 24, 2009 6:47 am, edited 1 time in total.
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