Alan Clarke has just written his first book called “Retire Richer”, a practical guide for all New Zealanders. Alan, an Authorised Financial Adviser, has been a financial adviser for 24 years.
For more information visit: www.retirericher.co.nz.
We are told by most financial commentators to pay off our mortgages as fast as we can. If you have some surplus income or 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 in New Zealand. 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 keep the bank (or other creditors) off your back.
It is usually quite easy to borrow money when we have jobs / normal health, but almost impossible to borrow if things are bad; like if you are made redundant, cannot work, are ill, or have had a bad accident.
Remember “A bank is an organisation that will lend you an umbrella when the sun is shining, but they will want the umbrella back when it starts to rain.” For all the reasons given above, it would be very wise to build up an emergency fund.
Dead money v 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. Conversely your emergency fund is an asset – if you never need it, you still have it.
How much should be in your emergency fund?
The rule of thumb I was taught in NZ back in 1991 was three to six months income. 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 eight months income in emergency funds. Given the extent of the credit crunch in the USA, eight 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 within say two weeks.
Where not to put it
The first consideration is not in the bank where you have your mortgage. If you miss a mortgage payment, the bank can move money from one of your accounts to another without even consulting you. Rental property, beach houses, forestry and commercial buildings are not suitable as emergency funds either as they are not liquid. Money from these assets can take months, if not years to unlock.
Nor should it be all invested in shares, since Murphy’s law says they are all too likely to be down 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, it will grow, and if it is never needed, it will become part of your retirement funding.
What sort of investments is recommended?
A highly diversified conservative portfolio of about 75 percent in bonds and 25 percent in shares is suitable. Bonds over many years have paid one percent to three percent better than short-term bank deposits. Shares have had a bad patch recently but over the longer term shares have out- performed bonds by three to five percent. Therefore, over time, returns from a correctly structured conservative portfolio over the medium to long term are likely to be about two percent per annum higher than bank rates.