A lesson Learnt: Emergency Funds and Risk Tolerance

There are some things in life that you can only truly learn through experience. Right now, what the world is teaching us (at least in terms of personal finance, there are many other lessons being taught too) is just how important it is to figure out our risk tolerance- and the need to have an emergency fund.

It’s not that you can’t learn about risk tolerance and the need for an emergency fund when the world isn’t facing a pandemic. You can read and think about them all you want. But when a pandemic hits is when we really take notice.

If you’re like me, you’ll have been fortunate enough not to have been through a major pandemics or market crash before. I started investing in 2010, and up until a few months ago, the markets have been on a decade bull run. The longest bull market in history, starting in March 2009.

I say we’re fortunate, but maybe we are just naive. I’ve never experienced a large downturn to test out my risk tolerance. I’ve never experienced the need for emergency funds.

Emergency Funds

It’s not that I don’t think emergency funds were necessary before- I have advocated the need for everyone to have an emergency fund previously– it’s that I thought I was special and didn’t need one. Sure- I’ve always had an emergency fund… of $2000 cash set aside, and then whatever is left in my bank accounts. But what COVID-19 has taught me is that this is not nearly enough!

The prevailing wisdom is that you should have around 3 months worth of your living expenses in savings. I could scrummage around and find some more liquid assets or even use a credit card. But it’s now clear to me that’s not very sensible. You don’t want to sell shares during a global pandemic like this and solidify your losses. Nor do you want to load the credit card with job security being on a knife-edge.

So in the future- I’m definitely going to build up a larger emergency fund than what I use to.

Since our holiday had been cut short- it’s not like I don’t already have an emergency fund right now. The holiday savings have now become my emergency fund. And we are fortunate in that we already have 6 months of mortgage payments put aside as well.

So we accidentally managed to enter into this pandemic with an emergency fund. And I can tell you that having this extra cash around really helps in dealing with the uncertainty of job losses or reduced hours.

You can get fancy on how you structure your emergency fund. You could set up a rolling set of term deposits- each staggered to mature at different times of the year. But in reality, having your emergency fund in cash will allow you to sleep more easily.

The peace of mind knowing you can access your emergency fund is probably worth more than the extra few percent interests you could earn.

The other fortunate thing during lockdown is that our expenses have dropped. It’s hard even to spend any money really. The only expense being food. No more petrol expenses, no more going out expenses, and no hobby expenses- I can’t even spend money on house maintenance. It is possible that my alcohol spending may have gone up slightly…

Risk Tolerance

Before this all started, I thought of myself as an aggressive investor- investing for the long term. Most likely 10 years or more. I’m looking to gain higher returns over the long term, even if that means big ups and downs in some years.

But you can only really know how comfortable you are with the big downs when they happen to you. It’s all well saying that you’re happy to lose +10% of your shares’ value. You’ll ride it out, right. What about 30%? How did you react in the recent crash?

I’m contempt for leaving everything as is right now. Even though it does hurts to see the value of my shares dropping by +$10,000 (see my bar chart in my recent update). I remind myself that I haven’t lost a thing- I still own the same number of shares as before- it’s just that their value has dropped.

Many people have run to the hills, jumped their growth ship and sailed into conservative.

This might not always be the best strategy.

History has told us that markets will recover eventually. Normally within 12 months, but no one really knows.

I know people are going to be screaming the mantra- historic returns don’t predict the future. Or that this pandemic is different to others. And yes there is truth in that. Nothing on this scale has happened since the Spanish flue.

But if you choose to believe markets will never return to normal- or even continue to decrease- then you’re basically saying that the world is never going to get out of this and return to some sort of normal. The value of shares to go to zero every company you have invested in will have to go broke. And if you’re like me and have invested in Index funds, you will have invested in hundreds or even thousands of companies. They will all have to go bust for your investment to go to zero.

And if that happens, there will be more to worry about than your investments. The Vanguard fund alone invested in 1500 companies. Microsoft, Apple, Amazon, Facebook, Nestle, Exxon, Visa. What will the world be like if these companies all went broke?

When the new normal hits- companies and business will be looking to make money, and hence earning projections will increase- followed by increases in the share market. I want to stay in the market until that eventually happens, and continue to dollar cost average until it does.

Changing strategy isn’t a stratergy

It’s been a challenging year to date. Everyone is being affected by the coronavirus somehow as countries around the world go into lockdown to deal with it. This causes a lot of uncertainty. And investors don’t tend to like uncertainty. And you may have seen this play out in the markets, with large swings in both directions.

The daily swings might make you think you need to do something. And many investors, both personal and KiwiSaver investors, are selling out of shares. That’s not always the best option. Ideally, if your risk profile has been set right, you should stick the coarse, which is exactly what I’m doing.

Changing strategy during this time of uncertainty is not a strategy in it self.

Selling up shares and moving to cash is not a strategy. Buy, hold, re-balance. If you go to cash because you are thinking the market hasn’t finished dropping, then get back in when it’s going up. You are timing the market- not just once, but twice—your timing it once on when to get out, and then twice on when to get in. And you’d be a fool to think you can predict when the best time to do either is.

Selling to cash creates one mental concern into two real concerns. The first concern you might have is that your shares have lost money- and believe me, it’s a concern. It’s happening to my shares too- but by selling you have made the loss real. And once you have sold, you have created the second real concern- when do you get back into the market.

Ultimately- people using this strategy tend to Sell Low and Buy High. Selling as shares have lost their value, and then waiting to get back in when the market is doing better. And by the time that the market is going good, you will have been too late and will end up buying high.

Staying the coarse doesn’t necessarily mean doing nothing though. Ideally you should re-balance into it and remember that you are investing for the long term.

Let’s say you have decided that a 60-20-20 investment portfolio in shares, property, and fixed interest (term deposits or bonds) fits your risk tolerance and investment goals. Then the world gets hit by a pandemic. After a while, you check your investments and find that your portfolio is now 40, 15, 35 in shares, property, and fixed income.

As long as you are investing for the long term, you could buy more shares to re-balance your portfolio back to were you have decided it to be. This could be either buying more shares or switching some fixed interest into shares.

Not this is not to say that you only do this in bad times. When the share market is going gangbusters, you might end up the other way- say 70, 10, 10. Then you should re-balance your portfolio in the opposite direction. Either sell some shares or purchase more fixed income and property funds.

If you re-balance now and then, you’ll always be in your desired risk tolerance. But don’t do it too often, especially when the market is very volatile as it is now. I tend to only look at it once a year around tax time.

Understanding Exponential Curves

COVID-19 was also a good lesson in understanding exponential curves. Exponential curves and exponential growth are the main reason why it pays to invest in the long term. You might have heard about the rule of 70 or sometimes the rule of 72, but I like to use 70 as it makes the maths easier in my head- and it’s closer to the real number of 69.3. The rule lest you calculate when your investment will double in value. Well, that rule is based on exponential growth.

The number 70 comes from the value of the natural logarithm of 2 times by 100 – The inverse of a logarithmic function is an exponential function- that’s how it’s linked. Either way- the details aren’t important. What is important is that you can use 70, and your expected return rate to calculate a doubling time.

Say you are getting 5% return on your investments, if you divide 70 by 5, you will roughly know the time it takes for your investment to double. 70 divided by 5 is 14. So it will take 14 days to double is size.

Exponential growth takes decades when we are referring to our investments. That’s why it’s hard to understand exponential growth- the time scales we deal with are too large. But COVID19 has exponential growth which happens in the order of days, which is much easier to get your head around and see the power of exponential growth.

Let’s look at the number of cases of COVID over time and extract some interesting facts about exponential curves. I’ve taken the numbers from WHO and plotted them below- starting on the 22nd of Feb as Day 1.

Now when you look at the date some shocking facts emerge. It took 45 days for the number of COVID cases worldwide to reach 100,000. But, once the total number of cases was up to 900,000 on day 71, it only took one extra day to add another 100,000 cases by day 72. That is exponential growth.

You can also see that I have fitted an exponential curve to the data, with the equation on the chart. From this equation, you can calculate the doubling time- that is the time it takes for the number of cases to double. The calculation is below.

Exponential growth COVID19
Calculating an estimated doubling time for the number of COVID cases worldwide

So the doubling time turns out to be around 10-days if the trend is to continue exponentially! And the 10-day doubling time holds consistent with the data.

Number of DaysNumber of CasesNumber of times larger
than previous 10 days
Day 0555
Day 10992717.9 x
Day 20427624.3 x
Day 30761971.8 x
Day 40883691.2 x
Day 501258751.4 x
Day 603045072.4 x
Day 708574872.8 x
Day 8016917192.0 x
Number of cases of COVID-19 every 10 days, which is the estimated doubling time (Day 0: Feburary 2020)

If that doesn’t convince you that the power of exponential growth is insane- then nothing will. In just 10 days the number of cases doubles. So in about another 10 days- if the lockdown measures didn’t work, we can expect to see 3.3 million worldwide cases. We have already hit 1.8 million so far.

Seeing the power of exponential growth over the last month or two might make it easier to stick to investing over a decade or two and let exponential growth take over- then again- I can’t tell you how to invest.

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1 thought on “A lesson Learnt: Emergency Funds and Risk Tolerance”

  1. Our emergency fund has pretty much been the same as yours. A few grand in the bank, a holiday fund and a credit card limit we’d never come close to maxing out under normal circumstances. Additional factors that we have in reserve as “emergency fund” are the option to take a mortgage holiday and accrued leave balances at work (which would be paid out should I lose my job).

    I’m fortunate to have a government job so while it’s not impossible for me to lose it, it would take more than a temporary pandemic to put my employment in jeopardy. Realistically though, we should create a proper emergency fund. Pandemics don’t come along all that often, but restructures do tend to happen on a semi-regular basis so you never know!


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