FOOL'S EYE VIEW
Emergency Reserves!

By James Carlisle
July 24, 2002

Following on from Maynard's article last Friday about asset allocation, I thought it would be interesting to expand on the question of cash reserves and, most particularly, how much you should be aiming to have stashed away. To get an idea of how much of a cash reserve we need, however, we first need to think about what it's there for.

A reserve of income

The income you get from working, or from elsewhere, should provide the lifeblood of your personal finances and the purpose of a cash reserve is to complement that. We don't need to have money saved in a bank account to pay for the pints of milk that we might need over the next couple of years, because we can easily meet those costs out of our income (we hope). We do, however, need a reserve of cash to take up the slack when our income can't cope. This generally means situations where there's a 'lumpy' expenditure that's large compared to your income, or when your income dries up for some reason or other. We can break it down into three main categories: planned events, semi-planned events and unplanned events.

Planned events

Holidays are the most obvious example of planned expenditures. You probably take a holiday once a year but you're unlikely to be able to afford it out of one month's salary. So you need to be saving a little in each non-holiday month, so that by the time the holiday comes along, you have enough to pay for it.

Assuming you take the holiday at the same time each year (and pay for it at that point), then one month after your holiday, you should have one twelfth of the cost of next years holiday stashed away. One month before your holiday, you'd want to have eleven twelfths of your holiday cost stashed away.

Christmas might be another example of a planned expenditure. If you reckon that it costs you an extra £600 per year, then you'd need to be putting £50 by each month to pay for it. In November you'd have £550 earmarked for Christmas and at the end of January you'd only have £50. You get the idea.

Semi-planned events

Beyond planned expenditures, there are one or two things that you might call semi-planned expenditures. These would be things that you know are going to hit you sooner or later, but you have no idea when. Repairs to your car would be one example. Another would be calling out a plumber/electrician/pest-control person to sort out your home.

These sorts of things are much harder to estimate. Coming up with the eventualities is hard enough, but it's even harder to put a value on them. How much will it cost to repair your car if you have some, as yet unspecified, mechanical failure? Well, how much did it cost last time? Even better, how much did it cost the last five times, divided by five?

And what about the plumber? How often do you need to call one round and what's the typical cost? One complication here is that you may be covered by insurance for some situations. So go and get your insurance policy from the bottom drawer in the kitchen and see what it says. In fact, you should have thought about all this when you decided what insurance cover to get in the first place. Insurance and your reserve of cash should complement each other: the more your have of one, then less you'll need of the other.

Another confusion is that, being 'semi-planned' you have no idea when these events are going to crop up. What if -- gasp -- they all came at once?! Here you have a bit of a choice, depending on how close you like to sail to the wind. If you're a cautious soul, then you might want to have enough tucked away to cover all the semi-planned expenditures on your list if they came along together. If you're the riskier sort, then you might cross your fingers and hope that you only get stung for one of these events in each year. If the washing machine blew up at the same time as the car broke down, then you might just have to live without one or the other while you get the money together for repairs.

Half the battle is in working out where exactly you sit on the risk scale. That will depend on your own attitude but, if you have a family and dependents, you'll also have to think about how they see things. Perhaps going without the washing machine or car for a couple of months isn't such a bright idea!

Unplanned events

Finally, you need to think about totally unplanned types of expenditure that might hit you. Here we're talking about redundancy, unplanned pregnancy, a sudden flit across the world because Betty in California is tying the knot – you know the sort of thing. This type of thing is, by its nature, impossible to quantify. Even so, it's easier for you than it is for me. Do you work as a civil servant or for a flighty start-up company? Are you having regular (or even irregular) sex without contraception? Are Betty's emails indicating a very cosy state of affairs with the love of her life?

After thinking about how likely any of these things are, you need to think about how they might affect you financially. You might be entitled to attractive maternity rights through your job, but then again you might not. If you lose your job, how much money would you leave with (in other words, how long is your notice period and what rights do you have to any redundancy)? How long do you expect it would take to find new employment?

If you're a couple with two incomes, or even an individual with two incomes, this will also make a difference. How likely is it that both incomes dry up at the same time? If both incomes are in the same sector of the economy, or even the same company, then the chances are greater than if one of you worked in advertising and the other as an insolvency practitioner.

You can drive yourself mad thinking about all the possibilities and that'll just make losing your job (and perhaps the pregnancy) more likely. Ultimately, deciding how much you need to cover unplanned expenditure is so hard that it becomes easy. You'd be very brave to live your life without enough to cover at least three months' expenditure whereas, assuming you're vaguely employable, you'd probably be overly cautious to have more than 12 months' worth. Most people, as ever will be somewhere in the middle.

Tot it all up...and stash it away

So, at any point in time, you'll want to aim to have your three to nine months' expenditure tucked away, plus what you might need from time to time to meet semi-planned expenditures, plus the rising and falling balance that deals with your planned lumpy expenditures like holidays and Christmas.

It's probably easiest to deal with the planned expenditures through a current account and use a separate savings account for the semi-planned and unplanned bits. Alternatively, especially if you've got a lot put by, it's probably more efficient to use one of the new flexible mortgages.

More: The Fool's Banking Centre; The Fool's Mortgage Centre; Flexible Mortgages