For the past four days the power has been out at Kung Fu Grandma’s house in Northern Michigan. A winter storm knocked down some critical power lines, and temperatures have been 0 degrees for four days in a row, causing much hardship and stress among all of our neighbors.

Our house (my childhood home) uses well water and has a septic tank (we live on a lake in the country with no “public city utilities”), so when the electricity is out not only is there no TV or radio or refrigerator/freezer power….there is also no water because the pump for the well runs on electricity.

Now in the summer this is no big deal (and is actually really fun if you are a kid)… I remember many an exciting and fun summer storm where we cooked and played by candlelight and flashlight and I ran buckets of water back and forth from the lake to the house to fill the toilet tanks, thinking that I was just like the pioneers we were learning about in school. I was even allowed to bathe in the lake (with biodegradable soap) and loved pretending to be a mermaid while frolicking in the waves—I was always so sad when the power came back on and life went back to “normal”!

However, it is not summer in Northern Michigan now…it is winter. Freezing cold winter, and the residents of our small town have fled to nearby hotels and used every generator they can get their hands on to warm their homes enough to keep the pipes from freezing.

Kung Fu Grandma is concerned…we don’t have a generator, and most likely the pipes have frozen and might break, causing a huge mess and a big expense. She’s not even home to be able to “do anything” about it…she has been here helping with the Kung Fu Kids while I’ve been traveling.

She’s not sure what she will face when she returns home tomorrow—frozen hot water tanks filled with ice? Broken septic pipes? Total disaster-mess-calamity? I sure hope not!

Thinking about this emergency reminds me of one of the cornerstones of kung fu and of personal finance—preparing for battle (and for emergencies!) and ensuring that you have a rock-solid emergency fund in place in case the unthinkable happens. As the saying goes, “prepare for bad times, and you will only know good times”.

Today my friend The Austrian, a Chartered Financial Analyst (CFA) charterholder, experienced investment advisor, and super-smart guy, shares with you how to build yourself a rock-solid emergency fund that can withstand any emergency—even a disruption to the financial system itself.

It’s time to prepare for battle! Are you ready?

To your financial success,
— Kung Fu Girl

Building a Better Emergency Fund

Are you prepared for a financial emergency?

One of the components of a robust financial plan is the establishment of an “emergency fund”—money set aside to help navigate financial uncertainty, such as unexpected expenses (medical bills, unexpected home maintenance, etc.) and extended unemployment.

The idea is straightforward—when times are good you should be producing more than you consume and saving the difference, and you can divide your savings into several categories:

  1. Short-term (stashing money away for the family vacation next year),
  2. Long-term (college, retirement, etc.), and most importantly
  3. Your emergency fund.

There is no “right” amount to have in your emergency fund, but most financial planners will state it in terms of number of months of income or number of months of expenses.

For example, one person may choose to have three months of post-tax income in the emergency fund, while another may choose to have six months of their average monthly expenses set aside.

The primary objective for an emergency fund is to preserve your purchasing power, so it defeats the purpose if you invest your emergency fund in a vehicle that subjects it to significant risk—Murphy’s Law dictates that you are likely to experience a significant investment loss at the exact time you need it most!

Therefore, it is common to see emergency funds invested in some combination of cash and cash-equivalent investment vehicles, typically denominated in your home currency (we’ll use the US Dollar for the purposes of this article):

  • Cash under the mattress,
  • A savings account/Certificate of Deposit (CD) at your bank,
  • A money market fund,
  • Short-term US Government Bonds.

This is “conventional wisdom” and is how most financial planners will recommend you invest your emergency fund throughout the world.

However, conventional wisdom is incomplete…it does not satisfy the primary purpose of an emergency fund (preservation of purchasing power) under some conditions. For example, what if the US $ (or your home currency) suffers a major devaluation due to inflation? This could be gradual or extreme (hyperinflation).

It is no secret that the US Government spends significantly more than it takes in (the exact opposite of sound financial management). It has managed to keep the wheels on the bus to date, but many financial professionals feel that it is only a matter of time before this unsustainable situation ends. Many of those same professionals feel that the US Government will take the easy road and print money to purposefully reduce the value of the dollar, making those debts easier to pay. Running the printing press overtime is not a new tactic used by countries deep in debt.

If the US were to enter a period of significant inflation/hyperinflation, most emergency funds would be decimated given the typical “conventional wisdom” investment strategy.

A quick read of history demonstrates that periods of high inflation/hyperinflation wreak havoc on economic activity. In extreme cases, barter systems and/or precious metals replace paper currencies as the medium of exchange while the monetary/economic system readjusts. (Kung Fu Girl Note: This has happened many times in many countries over just the past 50 – 60 years…Think Germany, Argentina, Zimbabwe…)

This would be an ideal time to be sitting on a large emergency fund, but your emergency fund may be worthless if it is denominated in the same paper currencies that are rapidly being inflated away.

So what is one to do?

The answer lies in a time-tested investment principle: Diversification. Or to put it another way, don’t have all of your eggs (emergency fund) in one (US$ denominated) basket.

Instead of having your emergency fund invested according to “conventional wisdom”, you should consider diversifying across different currencies (including precious metals as the ultimate currency).

Here are a few ideas:

1. First, you can diversify a portion of your emergency fund into precious metals (primarily gold and silver). This can be done using several methods. You can purchase physical gold and silver coins and store them at home or a safe deposit box (locally or overseas).

However, a word of caution is in order. Gold and silver have been experiencing enhanced volatility during the past several years, so you will most likely see more fluctuation in the value of your emergency fund if you invest a significant portion in gold and silver. Therefore, you need to determine what percentage of your emergency fund is appropriate to invest in precious metals based on your risk tolerance.

The advantage to using gold and silver is that they have historically been considered “money” and have demonstrated an ability to protect against a loss of purchasing power experienced by paper currencies. If there were a major bout of inflation/hyperinflation in the US, it is likely the price of gold and silver would continue to appreciate significantly.

2. Another option is to diversify your emergency fund using foreign currencies. The advantage to this approach is that you would be less dependent upon the US$. There are several countries with stronger fundamentals than the US economy, which means over the long-term one could anticipate these particular currencies appreciating versus the US$.

However, there are also risks in diversifying with foreign currencies. Today, during times of chaos, the US$ has appreciated against other currencies as the US$ is still considered a “safe-haven.” It is highly possible that in the future, the US$ may lose its safe-haven status and depreciate rapidly during times of crises. If this were to happen, you would be very glad you diversified a portion of your emergency fund into foreign currencies.

One way to accomplish this is to utilize a bank, such as Everbank, that specializes in foreign currency CDs and deposit accounts. You can also take the more involved step of opening a foreign bank account and hold your savings in the local currency. Similar to the discussion above about precious metals, you will need to determine how much to invest in foreign currencies based on your risk tolerance.

To summarize, most financial planners would agree with the concept of having an emergency fund meant to cover your expenses during times of unforeseen challenges such as those associated with major unplanned expenses, or extended unemployment.

I agree, but recommend that you take this one step further to truly protect yourself from a larger set of emergencies.

Sincerely,

The Austrian