We are told by most financial commentators to pay off our mortgages as fast as we can. It does not matter if you are a business person, salary or wage earner, you will be told the same.
You might be earning more, have had a good year, received an inheritance, or had a windfall, it does not matter. If have some surplus money, you will hear the same story again – reduce your mortgage, and in theory this is the correct advice.
However, what about building up an emergency fund ? There are good reasons to do so, and all too often this is overlooked by New Zealanders.
If you were to build up an emergency fund, you would have room to move in the midst of a financial crisis, or tough times, and have more flexibility to keep the bank (or other creditors) off your back.
It is usually quite easy to borrow money when we have secure jobs / normal health, but almost impossible to borrow if things are bad e.g. if we are made redundant , cannot work, are ill, or have had a bad accident.
Remember “a bank is an organization that will lend you an umbrella when the sun is shining, but they will want the umbrella back when it starts to rain.”
There can be many causes of an emergency:
Death of the family breadwinner
Death of the mother of a young family
Key staff illness or accident
Economic downturn in NZ
Poor produce prices
Rising interest rates
And some we even cannot imagine.
For all the reasons given above, it would be very wise to build up an emergency fund.
Dead money vs. an asset
We cover a lot of risks using life, fire, and general insurances, but the premiums are “dead” money that you don’t get back, and all too often insurances often do not cover the emergencies that arise.
Most life insurances nowadays are term life, where the premiums increase with age, and rise very sharply from around age 55. By building up an emergency fund, you gradually eliminate the need and eventually the cost of such insurances.
Hence your emergency fund is an asset.
How much should be in your emergency fund ?
It is impossible to come up with precise figures since you cannot know the size and nature of a future emergency. The rule of thumb I was taught in NZ back in 1991 was 3 to 6 months income.
Obviously the more debt you have the more your emergency fund should have in it.
Rocket science is not needed here though, and any amount is better than none. Getting started is the most important step!
In the USA they recommend everyone keeps 8 months income in emergency funds. Given the extent of the credit crunch in the USA, 8 months would have barely been enough for a lot of people,
Liquidity (access to money)
Emergency funds need to be liquid – they must be easily accessed. There is not much point having an emergency fund unless it is readily available with say 2 weeks.
How can you build an emergency fund ?
If cash flow permits, set up an automatic payment system and put the funds in monthly.
Or allow for contributions to it in your cash flow planning.
As always, seek a balance between debt repayment and living today as well.
Where not to put it
The first consideration is not in the bank where you have your mortgage. Emergency funds should be as far away from your bank manager’s control as you can get. If you miss a mortgage payment, the bank can move money from one of your accounts to another without even consulting you.
It needs to be under your control and preferably your bank should not even know you have it.
Rental property, beach houses, baches, forestry, and commercial buildings are not suitable as emergency funds either as they are not liquid. Money from these assets can take months to unlock (even years sometimes).
Nor should it be all invested in shares, since Murphy’s law says they are all too likely to be down 10%, 20% or even 30% at the time you need the money.
None of these assets are suitable as emergency funds.
Where should emergency money be invested ?
Hopefully you will never need the money for an emergency, and so it should be invested, but in a conservative place. Ideally it would be invested in a conservative diversified portfolio, with a portion offshore.
If it is invested, over time it should grow, and if it is never needed, it will become part of your retirement funding.
New Zealand is a tiny economy and is not particularly well diversified. Further, the New Zealand economy is highly vulnerable to earthquakes, imported diseases and pests. We have already had the Christchurch earthquakes, and the PSA disease in Te Puke’s kiwifruit orchards.
NZ is will continue to be at risk of imported pests / diseases that might attack our animals, orchards, crops, or forestry. In the event that New Zealand’s economy takes a big hit for one reason or another, it is likely that the New Zealand dollar would drop sharply.
If this eventuates, the value of your offshore emergency funds would be maintained.
What sort of investments is recommended?
A highly diversified conservative portfolio of about 75% in bonds and 25% in shares is suitable.
The bonds should be A rated or better, and the shares in the right kind of share fund, on & offshore.
The correct diversification dramatically reduces risk too.
Bonds over many years have paid 1% to 3% better than short-term bank deposits.
Shares have had a bad patch recently but over the longer term shares have out- performed bonds by 3% to 5%.
Therefore over time returns from a correctly structured conservative portfolio over the medium to long term are likely to be about 2% pa. higher than bank rates.
It is best to ‘stick to your knitting’ and do the things that you are good at doing. Therefore, you may be better off to use an AFA (Authorized Financial Adviser) rather than trying to pick good bonds and shares yourself.
Get started, even a small emergency fund is better than no emergency fund
Remember it is an asset, not an expense/cost
Always keep it well away from the bank where you have your mortgage
Make sure you can assess the funds within 14 days
Make sure it is controlled by you, no one else
Invest a good portion of it offshore to help counter any nasty downturn or disaster in NZ
Review your other affairs and insurances regularly so that the likelihood of needing your emergency fund is kept to a minimum
If your emergency funds are never needed, they will become part of your retirement funds
I was recently at a BBQ and was asked “what is the best investment ? ” I tried to decline but after some good natured bantering, I offered a short generalised opinion which was;
“Most people would do well to have some property, but not too much, some cash but not too much, some bonds but not too much, and some shares but not too much.
The bonds should be of high quality and the shares should be in the right type of share fund. Both bonds and shares should be on and offshore, and widely diversified.”
One could debate this for a week of course, (we did not at the BBQ) but in summary;
Not too much, just look at the Christchurch situation. In addition think about the removal of depreciation tax deductions for property investors, the Global Credit Crunch, & banks looking for bigger deposits.
Add the fact that people are reluctant to borrow heavily to buy property nowadays, and it seems pretty likely that property will be very slow for a long time. Remember too that property is not liquid, as you cannot get cash out of it in a hurry.
Not too much as cash earns very little interest, especially after tax; however it is safe and available at short notice. When things are bleak and you need money in a hurry, cash is king.
I note that Suzie Orman on CNBC recommends people in the USA keep the equivalent of 8 months income in emergency cash reserves – probably good advice.
Over many years bonds have outperformed cash by about 1% to 3%. However not all bonds are equal, and they range from almost no risk down to junk.
It is important to stick to the high quality end and diversify widely, both in NZ and offshore.
Shares over time outperform bonds by about 3% to 5%, but it takes time and you must have the right type of share fund – asset class funds such as DFA are superior. The wrong type of shares are those which are not well diversified, and those where someone is stock picking or forecasting – it does not work .
That is the conclusion reached over many years of research by Eugene Fama, winner of the Onassis prize for services to global finance in 2009.
Cash, bonds and shares are all liquid too, meaning you can access cash at short notice too, something you cannot do with property.
The BBQ food was ready by this time so I concluded with;
“If you spread your money around like this, you will make good money when things are good*, and you will also survive any bad times pretty well too.”
* Historically share markets have had many more good years than bad years.
Disclaimer – this publication has been prepared for your general information. Whilst all care has been taken in the preparation of this publication, no warranty is given as to the accuracy of the information and no responsibility is taken for errors or omission. Alan Clarke Financial Services Ltd will provide you with an investment disclosure document at no cost before offering you any specific advice.