You earn more than you spend. Fantastic!
The debt monster no longer threatens you. Excellent!
But before you dial up that stock broker, there’s one more thing you absolutely must do.
Don’t invest without a safety net
When you look at the long-term performance of African stock markets, it’s clear that there are no guarantees that the value of any given share is going to rise.
The Nairobi Securities Exchange has dropped 3.4% over the past month. The Nigerian Stock Exchange has fallen more than 27% since last April. And the Botswana Stock Exchange’s main index was worth more five years ago than it is today.
Now, that’s not to say that you shouldn’t invest in shares. Far from it. Over the long-term, very few investments come close to matching the performance of the stock market.
But there will most definitely be bumps in the road. And if one of these stock market bumps happens to coincide with a rough patch in your career or personal life, it could leave your finances in a shambles.
If you invested all of your savings in shares, what would you do if the stock market took a nosedive at the same time you were retrenched from your job?
The shriveled value of your shares may not be enough to sustain you and your family until you find new employment, which could leave you little choice but to tangle with the debt monster once again.
This is why you need an emergency fund. It’s a safety net in the event that the stock market and your disposable income drop simultaneously.
Make sure it’s big enough to support you
To figure out how large an emergency fund you need, take a look at your monthly income and expenses chart.
(You are keeping track of them, right?)
Look closely at your total expenses over the past six months. Add them all up.
The resulting sum is the target amount for your emergency fund.
Why is six months of expenses the magic number? Because this is a reasonable amount of time for you to find a new job or otherwise replace your lost income if you’re suddenly unemployed.
Does six months seem too short? Then, by all means, save more. Build an emergency fund equivalent to nine, 10, or even 12 months of expenses.
But don’t go less than six. The job market can be tough, and it’s amazing the peace of mind that an ample emergency fund can bring.
Put it to work
Now, where should you stash all that emergency cash?
Not behind the wardrobe. Not in a coffee can. Not sewn into the hem of your bathrobe.
Not even the cleverest of hiding places will protect it from inflation.
Bankelele is one of my favorite financial bloggers.
A wise ex-banker, Bankelele tracks the price of common Kenyan household items over time. In December 2009, he noted that a two-kilogram pack of maize flour cost KES 83.00. Five years later the price had risen to KES 101.00. Over the same time period, the cost of sugar rose 25%.
Clearly, inflation will decimate any cash that you allow to become lazy.
Where to stash your cash
So, where should you put your rainy day money to work?
It should be invested in a vehicle that is
- guaranteed against loss of principal,
- readily accessible in the event of emergency,
- and pays a healthy interest rate.
Many banks offer savings accounts that meet all three of these criteria. Here are a few that I’ve come across recently:
In summary, a healthy emergency fund lessens the likelihood that you’ll be forced to wrestle with debt if your share investments turn sour.
Do you already have a comfy emergency fund? Fantastic! It’s now time to explore investing in shares.
Stay tuned for future articles as we explore exactly how the stock market works.
How many months of expenses do you think is adequate for an emergency fund? Where do you think is the best place to stash it? Let us know in the comments!