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Managing Uncertainty with Protective Reserves

Managing Uncertainty with Protective Reserves

July 01, 2020

The condition of the world today has highlighted that we not only face risks but also face the uncertainty that accompanies the turmoil caused by the risks. The economic downturn, levels of unemployment, and challenges to maintain our financial wellbeing have caused much angst and general trepidation.

We have seen businesses, individuals, and even some levels of government encounter significant financial problems because they have not set aside sufficient reserves to bridge the demands on their cash flow.

The Federal programs, especially the unemployment insurance, have helped for the short term, but these are not a solution. They are exactly what they state, a short-term bridge.

Society at all levels has depleted the reserves for emergencies which now must be replenished. That will not be an easy task. With less income, setting aside money to rebuild the reserves will be even harder.

The studies and statistics about personal savings and reserves have been disturbing for many years. Now we are seeing that many businesses, large and small, are inadequately funded and prepared. We will soon see the problems faced by government at all levels when the depth of the cost and meager ways to replenish the reserves. Prepare to be startled at the high degree of the challenges ahead.

The message today is that every household needs cash during uncertain times. Too often the discussion is about risks. Managing risk is just one part of the task. We can never eliminate risks. We can, however, do much more to manage the uncertainty which comes from the risks.

Payroll disruption is just one possibility. Others include distressed business, major investment loss, extraordinary health care expenses, or some other calamity. The most damaging financial events are those which cannot be anticipated or quantified. During times of uncertainty, transition or distress, cash is king. In fact, every household should have an emergency stash. Or perhaps you would prefer the term protective reserve.

Consider for a moment how much less the current situation would be if every household had a three to six month reserve. Granted saving that much is difficult, but likely less difficult than dealing with the consequences of not having the reserve.

The relevant question is how much reserve cash is appropriate to weather a financial storm. Too much cash is inefficient, while too little cash may turn a short-term cash flow crunch into a long-term financial struggle. Estimating the proper amount of emergency cash is more than academic. Proper liquidity can preserve your credit, buy time for a prudent job search, fund a career change or business start-up, and shelter your family from needless anxiety. Here are general principles to consider for creating an emergency fund:

Determine your spending needs. The family’s monthly budget (not including taxes or business expenses) is an important reference. The size of the emergency fund should be calculated in multiples of the monthly budget. This helps you scale cash flow to actual needs.

Gauge your income stability and longevity. The next question is how many months of expenses to budget. A commonly suggested amount is six months, but this may not be right for your specific circumstances. Certainly the current pandemic has overwhelmed all these parameters and caused estimates to be too low in actuality.

As a general rule, the more stable your income, the lower the amount needed. Here are factors that add to financial stability:

  • More than one income earner in the family
  • Different professions, employers, etc.
  • Recession resistance
  • Job security, seniority, etc.
  • Income certainty (e.g. salary or commission)
  • Job skills and marketability

These variables generally apply across the job spectrum, including tradespeople, company employees, business owners, professional services providers and contract workers. More stability translates to less money needed for an emergency fund. Less stability increases the needed amount.

Consider the comfort factor. Four months of expenses is probably a minimum for emergency cash. This would apply to someone who could easily find new employment. In extreme situations, you may need more than 12 months of liquidity. Most households fall in the range of four to six months. There is no formula appropriate for everyone. The most realistic amount is the one giving you comfort and peace of mind. How much uncertainty can you tolerate?

Hold the cash efficiently. Your cash is your first line of financial defense. So, easy access is more crucial than rate of return. Holding the money in a bank account is quite appropriate, since the account is stable and easily accessible.

Family circumstances are important. A young or middle-age household may approach emergency planning differently than a retired or semi-retired couple. The breadth and depth of your investments and sources of money will influence how you structure your finances.

The lesson from recent events is that everyone should have an emergency fund for protection and peace of mind. Nobody expected the financial severity of the current situation. Your task is to prepare for the uncertainty. With cushions in place, making the important family decisions will be less stressful. Do not neglect it and do not begrudge the money just sitting there most of the time. It is, simply put, a shock absorber. Certainly we have all become believers about unexpected events.