Everyone needs a safety net. The question is how much? When I've told some people that they should have six to nine months they choke. They just can't imagine it.
So, let's think for a moment about a tightrope walker. Even the most daring and experienced use a safety net. If you are daring and experienced in finance and you are willing to take the risk of losing a home or other assets, then perhaps you don't need a safety net. If you run a really tight ship and don't need much to live on, then perhaps you don't need a large or strong safety net. However, most people don't even think about it. They just know what they make and the spend it (or more). Then when they have a financial crisis or lose a job, they act surprised.
Step 1 in deciding how much of a safety net you want or need is to determine how much risk you have of falling. Do you have a very stable job? Is this the job you plan to have for a long time? If you work in a minimum wage job and plan to be there for a long time and you work for an employer that has almost no chance of failing, then perhaps you only need a month's wages. I'd say that's the absolute minimum.
Step 2 in calculating your safety net is to determine how far you can fall. If you lost your job and had to get a new job immediately, what is the most likely replacement job you could get and how fast could you get it. If your car broke down, how much would you have to spend on a new car or on repairs. What is the gap that you'd need? For example, if you currently make $50,000 per year, but the current market indicates that a new job would only pay $40,000 per year, then you need to calculate that into your safety net. In addition, if you are one of those people who manage to live on far less than you current make, then you can lower your safety net compared to your salary.
Step 3 in calculating your safety net is to determine your fixed expenses. What is your rent, insurance, utility and food payments combined? What do you need to live?
Once you've quantified each item, you are ready to determine your safety net strength and size. Many advisors recommend three to six months of take home salary. Of course, this is a rule of thumb. It's possible that you can get away with one or two months. If you have a stable job, jobs in your field pay about the same no matter where you go and are relatively easy to find, and your expenses are less than your normal take home salary and you are a person who is willing to risk the chance of having to take a major change in your standard of living at a moment's notice, then a month or two may be good enough.
The reason that three to six months is used as a rule of thumb is that most people spend what they make or are in debt. In addition, most people can't find a new job immediately. In the current economy, it's tough to say which jobs are stable. The final element to consider is that "stuff happens."
So, if two months of take home pay is a rough minimum. Then is there a maximum? Why is six months usually listed as the maximum. There are a couple of reasons. First, if you are in a higher than average paying job, then it will likely take longer for you to find something, especially in a down economy as we are experiencing now. I have friends who have been underemployed now for over a year. They are employed, but sometimes at half of what they were making two years ago. In that case, their savings and investments (combined with a reduction in expenses) is making up the difference.
In these cases, it would have been nice if these families had close to a year's worth of take home pay saved. But they are making it. Why wouldn't you want to save a year's worth of take home pay? Well, if you are very conservative you might! That may scare you, but you might want to do that!
One reason not to is that it's unlikely that you'll end up in that extreme of a situation and that saving a year's worth of expenses is really tough. It might take you years to do it. In addition, the safety net account should be in a very conservative investment. It should be in a Money Market mutual fund or at most risky, an intermediate term US Treasury type fund. In other words, it should be a very safe and stable investment. The downside of that is that if you have too much money saved in such an account, it's not going to earn much. It may not keep pace with inflation. Therefore, you don't want to keep more in your safety net account than you need.
In my case, I have a safety net account that includes very safe investments for approximately three months of living expenses. I then have other accounts that I can access easily, but are in somewhat more "risky" investments. It is roughly tiered so that money that I might need, but don't think I will is in a bond fund. Other money that I think is unlikely for me to need as part of a safety net is invested in a relatively conservative stock fund.
Which leads to the next post coming: Why should I invest?
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