How Big Should Your Business' Emergency Fund Be?

Have you ever seen that typical dad with a garage or basement full of random tools, spare parts, and straight up junk?

They swear this stuff will come in handy someday, somehow...

Maybe you are that dad. Maybe I am becoming that dad right now...

Usually, the benefit of all this clutter is far outweighed by all of the mental fatigue it causes, and all of the wasted time you spend sorting through it looking for stuff. We do this because we have a biologically hardwired aversion to risk: even the small risk of wasting a few bucks on random chunks of lumber.

What if I told you that our approach to emergency funds comes from that same psychology?

Why Have an Emergency Fund?

While it is true that most people wander blindly and do not keep enough in emergency reserves, there is another class that is way, way too prepared. This excessive prepping can drag down your returns and productivity. But on the flip side, it can also protect you if stuff really does hit the fan.

It is probably illogical to keep 3-6 years of food in your house like a doomsday prepper. But it is also probably not smart to keep only 3-6 days of food: stuff happens, and getting to the grocery store can be hard. Beyond the wasted costs of over-prepping and the costly fixes required of under-prepping, there is a mindset danger to both of these. Obsessively focusing on penny pinching and contingency planning is going to slow down your personal and business growth like water on a campfire. And ignoring reality while simply hoping for the best leaves you vulnerable to costly mishaps like driving an old clunker with a propensity for leaving your stranded on your way to the office.

Deeper Dive on Business Owners

In the Financial Planning world, the CFP? Board (CFP? stands for CERTIFIED FINANCIAL PLANNER?) is the most prestigious body of knowledge and certifying authority, akin to the American Bar Association for the Legal profession. I can verify the rigor of the CFP? Exam and educational material firsthand. The CFP? Board has set the precedent for most financial planning fundamentals through decades of extensive research, and has made some blanket recommendations for emergency funds. Individuals with a steady consistent income that is not the family's only source of income only need to have 3 months of emergency reserves. Individuals should have 6 months of reserves available if any of the following circumstances are present: sole breadwinner for family, high-turnover industry, uneven cashflows, highly specialized role with smaller number of openings in their region, higher than average expenses, etc.

You probably noticed that entrepreneurs fit firmly into the second category in most regards. So much so, that I almost always recommend that business owners have a full year of emergency funds ready to deploy if need be. It is not just the uneven cash flow that warrants this, but that it can take a lot longer to turn the ship around on business revenue than simply finding a new job as W-2 employees have to manage. Beyond that, employers are far more likely than employees to get sued, have unforeseen fines and expenses, and to have large replacement expenses for property used to produce a profit. Not only that, but having to lay off skilled employees who are great fits for your team in short seasons of revenue slumps can slow down your future growth substantially.

I recognize that saving up an entire year's worth of operating revenue is no small feat, but it might just be the simple decision that saves your business in the future. In Morgan Housel's bestselling book, The Psychology of Money, he reveals his findings that investors like Warren Buffet are successful simply because they never got taken out of the game prematurely, and were able to stay in the game for the long haul which is the single biggest guarantor of success. Berkshire Hathaway had another partner early on besides Warren and Charlie, but he blew himself up with too much leverage (debt that turned out to be bad debt) early on and was forced to sell to Warren and Charlie to pay off his debts. If he simply stayed in the game long enough, he would have gone on to success like his former partners. You get to make that same decision for yourself: will you play the long game and win or flame out too soon by taking unnecessary risks?

Best Assets for Emergency Fund

My biggest gripe about emergency funds is the misconception that they have to be kept in cash. This just is not true, contrary to what some financial talk show hosts will tell you. While cash has at least outperformed Gold since 1984 in terms of value (the gold salesmen on TV will never tell you that) it has really underperformed inflation. Those who put their cash in the bank will watch as their purchasing power erodes, and the one year emergency fund they had stashed away five years ago is now only worth 8 months. It certainly has a place, but is not the only option. Below are some of the best choices I have found.

Credit Card

Trust me for a second: credit cards are not all bad. If you can access the money needed to repay them within the rolling monthly period then all is well. If you lack the liquidity or discipline to pull this off, avoid this strategy and save yourself from paying 20% in interest. I can't remember the last time I saw an emergency that required physical, tangible cash within 24 hours. That is, except for paying the ransom to the guy who kidnapped your child. Credit cards are not good for this.

Physical Cash

Probably the best use of hard cash is paying the ransom to get your child back as mentioned previously. Otherwise, keeping your emergency fund in a safe, under your bed, in your freezer, in your walls, etc. is taking on unnecessary risk. People might find out about it and try to steal it, or your house might burn down. I have no problem with people keeping a few grand in their gun safe but there is not really any benefit beyond that. It helps out if there are extended power outages in your areas for a week so you can buy simple supplies, but it does not have the chance to compound and grow.

Cash at the Bank

A bank takes your money, invests it somewhere else, and promises it is available instantly to you if you need it. They do this at scale. Hopefully, not too many people will come asking for their money all at once, because it is out somewhere else being invested. Despite this Reserve Deposit system sounding and sometimes being kind of fragile, banks are very secure places to keep your cash. You give up the opportunity for yields that the bank is getting on their investments using your money for the promise and guarantee that it is available to you when you need it.

Interest rates at banks fluctuate depending on the actions of the Federal Reserve. in the rate hiking era of 2022-2023, bank interest rates went from 0.02% up to 4% in some cases, depending on the financial strength of the bank in question. Many banks could not keep up with the higher rates because their own profitability was too weak. You can keep cash at the bank, preferably in high yield savings accounts, for the purpose of security and a small interest yield. This is normally a foundational part of any emergency reserve strategy.

Money Markets and Money Market Mutual Funds

Banks offer money market accounts for clients to utilize that can increase the yield they are getting, often by a full percentage point or two above savings accounts. This is because the investments they are making with your money are ever so slightly riskier than in your savings accounts. These are short term debts usually ranging around a couple day loan from one bank or major business to another. It is worth noting that these are usually FDIC insured, but not always.

Instead of letting the bank keep the difference, or spread, between what they pay you for use of your money, and what their investment actually yields, you can access those conservative investments yourself. By using a Money Market Mutual Fund, you buy a packaged mutual fund that is committed to investing in the same types of things as bank money market funds, but gets paid by their expense ratio, which is usually smaller than the profit margin of a bank. For example, I have seen many Money Market Mutual Funds leading bank money markets by a full percentage point as of late, with after fee yields over 5%.

These are liquid within a couple of business days and are widely used by big institutional money like University Endowments, non-profits, and more. The only real downside of using one of these for emergency reserves is that they are not FDIC insured. That being said, while the interest yield rate can go up and down on these funds, the actual value per share is usually fixed at $1 exactly, so you do not lose money unless the fund goes completely insolvent. Back during the Great Financial Crisis of 2008, two of these funds saw their price per share drop from $1 to $0.97, a 3% decline, and were bailed out by the Federal Reserve within a few hours. So these really are pretty secure.

CDs

If you are a fellow Millennial or from Gen Z, you probably thought your grandparents are talking about those things that music and movies used to be stored on when they talk about these "CD" things. In the financial world, CD stands for Certificate of Deposit, which is a fancy way of you promising to lock up your money with the bank for a set term, like 6 or 12 months. This is normally the way to get the highest possible yield in an FDIC insured investment, and is super secure. The biggest downside to CDs are the fees they charge you to try and get out early, which kind of negates the whole "emergency" concept of an emergency fund. I have seen one decent strategy work with these however, when people ladder a number of CDs together as just one portion of their bigger emergency fund, so that one CD is coming due every single month and available if needed.

I want to take a moment though to issue a warning. Your grandparents love CDs so much because they are likely terrified of losing money and don't care about getting a yield that even beats inflation, most never do. These are not a good retirement strategy for most people. Older generations got really attached to them back in the early 1980's when they yielded 14% per year, but of course, mortgage interest rates were around 17% then, as your older relatives love to rub in your face ignorant to the fact that young people are facing the least affordable housing market since 1952. People remember the high tide lines and grow irrationally attached to things that underperform inflation now, and even did back then in an age of high inflation. Sorry, soapbox moment done.

Boring and Undervalued Stocks and ETFs

Finally, I usually like to have at least a portion of my own emergency fund consist of a basket of boring and undervalued stocks. Something that is unlikely to lose much if it goes down further, and unlikely to go up very high if it does go up. I look for decent dividend yields when I am selecting these, and for good defensive properties that increase the odds my money will be available if I really need it now, or at least most of it. Everyone's risk tolerance is different, I get it, so this is not for everyone.

My thought process is that this is my last financial line of defense within my emergency fund before my more permanent assets are breached like my retirement accounts, my cars, my house, etc. It is unlikely that I will ever have to touch this if I am properly insured against major risks like liability, cyber-security, life and disability, and more. Therefore, I might be fine with putting 20% of my emergency reserves or more into the stocks of certain specialized companies' stocks and ETFs with dividend yields of 10% or more with stable value, or companies yielding 4% on their dividends but with growth prospects to their price. The point is that I stand a good chance of beating the rate the bank will pay me and worst case scenario, I probably will not lose that much if I lose. Though with any stock, of course, the company could go bankrupt and you could lose every penny of your money invested in it.

Wrapping Things Up

You can probably guess by now that the best strategy is some blend of these types of emergency fund asset types uniquely tailored to your situation. Business owners should generally keep a year's worth of liquidity on hand, but that can vary based on your industry. I could give you a formula here like: 3 months in the bank, 6 months in a money market mutual fund, 2 months in really conservative ETFs, and 1 month in diversified boring stocks, but that is just too simplistic for your unique situation. If everything you have is sitting in under your mattress though, waiting for a house fire to consume it, this might be a helpful place to start. Partner with a great CERTIFIED FINANCIAL PLANNER? today to make a plan that works for you and your business's unique cash reserve needs.