Emergency Fund

The novice investor is often impatient to invest his first savings in the stock market. He has amassed a small nest egg and is eager to see it grow. He makes his little calculations by setting profitability objectives and develops various scenarios from this point. His first questions most of the time revolve around the number of securities to hold in the portfolio, trying to square the circle: how, with a small portfolio, can you be sufficiently diversified, without paying too many brokerage fees? Investors who have not gone through these questions, raise your hand!

However, before investing in the stock market, anyone seeking financial independence should start by securing their rear bases. Before looking to the future, the past must be regularized and the present preserved. This means first and foremost that debts based on consumer credit must be erased. Unlike credits taken out to buy an asset, such as a house, these debts are based solely on expenses and only serve to make you a little poorer.

To secure the present, and before investing, it is necessary to ensure that life events cannot have a hold on you. This is what makes the difference between the rich and the poor. How many times have you heard that someone could no longer pay their bills because of an unforeseen expense, such as the dentist for example? You must plan for this kind of inconvenience, and no longer count on luck. Sooner or later, it happens, and if you are not prepared, you will have to get into unnecessary debt.

The novice investor is eager to invest his savings so that they will earn him a capital gain. But if he has not taken care beforehand to keep an emergency fund for this type of event, then he risks having to sell all or part of his shares, subject to trading costs, and with capital losses. It is very frustrating to have accumulated royalties and not to be able to invest them to the detriment of an emergency fund, but it is even more painful to have to sell his shares at the worst possible time.

Such a fund offers the opposite advantage, that of having an abundance of cash in the event of a major drop in stock market indices. Some supporters of emergency funds will cry scandal, but personally I think that this manna should be used for exceptional events in life and stock market crashes are one of them. Of course, if we proceed in this way, any other investment will be prohibited before the fund is reconstituted.

Another significant advantage of this reserve is being able to insure yourself against life's small risks. You should know that insurance companies take roughly 15 to 20% in "administrative" fees from your risks. This means that in the premiums you pay, most of the time in vain, a fifth of the amount goes directly to pay the insurers' salaries. The rest will go to cover the risks of other insured parties or in the best case scenario one of your claims, as long as the insurance company is not picky, which is often the case. Rather than playing this little game, plan for these life hiccups and adjust your emergency fund accordingly.

How much should you put into this reserve? It depends on your lifestyle and the events you expect to face. Here are a few in bulk:

• Medical/dentist fees
• Theft of a wallet
• Taxes
• Change of car
• Repair in the house
• Loss of employment
• Stock market crash
• Fine
• Lawyer's fees

The list can be long. What matters is to clearly define what you want to cover with this fund, set your budget accordingly, and stick to it. This means that you cannot use this sum for events that are outside the scope you have defined, such as for a vacation (although you could do so if your fund has been revised upwards... but in this case it would be better to create a new fund specifically for vacations).

So how much? It is clear that you cannot insure and plan for everything. Insurance is there for the biggest problems. If you decide to stick to emergencies in the strict sense of the term, you will need to be able to cover a minimum of 3 months of expenses. If you adopt a broader definition of emergency, bet instead on a minimum of 6 months of expenses. This means that your savings capacity is paramount. The more you can save, the less of an emergency fund you will need. So, if you can save 30% of your net income, you will need a minimum emergency fund equivalent to 2.1 months of salary.

Your savings capacity is also important to build up this emergency fund. In the example above, it will take you 7 months to build up the minimum fund, which is still reasonable. Whether you are setting up this reserve, or saving with a view to investing your money in the stock market, the principle remains the same: you must pay you first, by systematically putting aside a portion of your income, before expenses. As long as the fund is not full, or if it has had to be used for an emergency, savings should be used first to rebuild reserves.

It's true that it can be demotivating at first, knowing that you had to work hard to put some money aside to invest your money in the stock market. And now you'll have to wait even longer to build up additional cash reserves. But this emergency fund allows you to sleep soundly and therefore not panic at the slightest stock market upheaval, which is the weak point of many investors, especially at the beginning.

Building an emergency fund helps you realize the ability to build up cash reserves. In the stock market, it is better to be patient, to wait your turn with enough cash, to buy large positions at a good price, rather than to waste significant brokerage fees to buy only a few hundred dollars of shares. Of course, your banker will tell you the opposite...