Fact: A frightening number of Americans are ill-equipped to handle a financial emergency. A recent GoBankingRates study found that 69% of Americans have less than $1,000 available in savings, while 34% have no savings whatsoever. These findings echo those of a Federal Reserve Board report stating that 47% of Americans couldn't cover a $400 emergency without having to borrow money or sell off possessions to raise that kind of cash.
But while not having enough emergency savings is a major shortcoming, stashing too much money in an emergency fund can hurt you as well. And while fewer Americans run into the latter problem, if you're a natural saver who likes to err on the side of caution, you should be aware that overfunding your emergency account can limit your ability to grow your wealth over time.
The downside of emergency savings
The point of an emergency fund is give you immediate access to money so you're covered when an unplanned expense arises. For this reason, your emergency fund belongs in a savings account, where the principal amount you put in is always guaranteed (at least up to $250,000 per depositor). The problem, however, is that most savings accounts today pay 1% interest or less, which means the money in your bank isn't really growing.
Imagine you have a $20,000 emergency fund earning 1% interest. If all goes well, you won't ever need to touch that money. But after 30 years, you'll have grown that sum into just $27,000.
Of course, the point of an emergency fund isn't to grow your wealth; it's to have a safety net in place for the unexpected. But if you put too much cash into an emergency fund, you risk falling short when you need that money in retirement.
What should your emergency fund entail?
Most people need enough money in the bank to cover three to six months' worth of living expenses, but under certain circumstances, it probably wouldn't hurt to have more. If, for example, you're self-employed and your income is variable, having nine months' worth of living expenses stashed away is perfectly reasonable. Similarly, if you have a spouse, several kids, and a mortgage, and you're the sole breadwinner in your family, you may want to push for that nine-month target, or even slightly higher. But if you're a dual-income family with reasonably secure jobs, you probably don't need to keep more than six months of living expenses in the bank. And you certainly don't need a year's worth or more.
While it's certainly better to have more emergency savings than not enough, if you keep too much money in the bank, whether due to your fear of the unknown or fear of the stock market, you'll severely limit your opportunity to benefit from the power of compounding. And that's a decision you might come to regret when you're older.
Striking the ideal balance
The general rule for stock investing is that you shouldn't have a particular need for the cash you're putting in for at least 10 years, because that's how long it might take to ride out enough market volatility to come out ahead. If you've saved adequately for emergencies based on the aforementioned guidelines, and you don't need your excess cash to, say, pay off a large debt or put a down payment on a home, then whatever extra money you're able to save should absolutely get invested.
Better yet, it pays to invest your excess cash in a tax-advantaged account like an IRA or 401(k) so you can truly optimize your returns. Not only do traditional IRAs and 401(k)s let you make tax-free contributions, but your money can grow on a tax-deferred basis over time. With a traditional brokerage account, you'll pay capital gains taxes any time you sell an investment at a profit, but with an IRA or 401(k), you won't pay taxes on growth along the way; you'll only pay taxes when you take withdrawals during retirement.
Just as importantly, a stock-focused portfolio can do far more for your money than a bank account ever will. Let's say you've funded your emergency savings and have $20,000 left over. As we saw above, in a bank account earning 1% interest, you'd accumulate just $27,000 in 30 years' time. But if you were to put that $20,000 into stocks and earn an average 8% return over 30 years, you'd have $201,000 -- 10 times as much as your principal contribution.
While putting money aside for emergencies is undeniably the responsible thing to do, the key is to strike the ideal balance between saving just enough without going overboard. Overfunding your emergency account could end up constituting a major financial setback, and as someone responsible enough to save money in the first place, you clearly deserve better.