None of us can anticipate all of our expenses. Every stage of life brings a whole new set of unanticipated needs. Even after identifying every outflow you think you might have, there will still be significant unexpected costs.
For this reason, nearly every financial blog suggests that you have an emergency fund. Many recommend saving a fixed dollar amount for emergencies, such as “set aside $10,000 for emergencies.” However, what if the dollar amount you pick isn’t enough? Also, after you spend your emergency fund, from where do you get the money to replenish it? If you’re either spending everything else or saving it for retirement, it is unclear how you should replenish the funds. Do you jeopardize your retirement next time?
For these reasons and more, we recommend constantly budgeting for surprises by setting aside at least 10% of your budget each month into an “Unknown Budget.” We call this budget the Unknown Budget because the question everyone asks is, “Like what?” and that is the point. You do not know how you will spend this budget.
We all have irregular and unexpected events that adversely impact our finances.
Your hours are cut back. You are widowed. The car breaks. You need to go to the emergency room. The roof leaks. You need to fly to a family funeral. Your daughter gets married. Lightning strikes a hole in your roof.
In economics, these are called financial shocks.
When you are always contributing to and replenishing your unknown budget, you are protecting yourself from the financial shocks that life will bring you. Although many years this budget might accumulate in long-term savings, you will also unfortunately use this budget more than you’d think.
In 2015, the PEW Charitable Trust analyzed the frequency and impact of household financial shocks . They found that 60 percent of households experienced at least one financial shock in the past 12 months.
They studied the frequency of five specific shocks as well as a catch all “other” category. Their findings were as follows:
|Financial Shock||Percentage of Respondents|
|Major car repair||30%|
|Major home repair||24%|
|Trip to hospital||24%|
|Other large expenses||10%|
|Divorce, separation, or widowing||4%|
|Any of the Above||60%|
Sixty percent of respondents experienced a financial shock with many of them experiencing more than one in the past year. The most common financial shock was a major car repair with a three-way tie for second between major home repair, trip to hospital, and pay cut.
Even knowing that one of these might be your next financial shock, there is no way of knowing which of these financial shocks you will experience next. It is impractical to have a “Hospital Budget” that is separate from your “Pay Cut Budget.” Instead, because you can’t anticipate and budget for every possibility, it is better and easier to budget for all of the unknown unknowns together.
The easiest way is to budget with a percentage of your overall budget, such as our recommended 10%. You could also try to estimate expenses by looking closer at the most common financial shocks and getting an estimate of what a safe savings amount for each might be for your family.
If you are using an automatic savings technique, you can simply transfer 10% less to your checking account each month so that you leave behind your 10% unknown budget in invested savings.
You should keep your unknown budget as fully invested as possible. At a 7% rate of return, the unknown budget you don’t spend could double every ten years.
In the event that an emergency happens, investments can be sold and the cash will be available two business days after the trade settles. With one processing day, the money can be transferred out of one custodian and into your checking account. After any bank-imposed holds clear, the funds can be used to pay the emergency bills. All of that might take just over a week. In the meantime, putting the emergency expense on a credit card with no monthly balance buys you a thirty day interest-free loan. If your credit card does not have a high enough limit, you might be able to utilize short-term margin in your brokerage account while you wait for the trades to settle.
In our family, when we experience a financial shock, we often say to one another, “I’m happy that this is a problem money can solve.” So many upsetting things in life money cannot solve. However, by living 10% more frugally while investing those savings, it is possible to be prepared for financial shocks. When you are constantly budgeting for unknowns, financial shocks are no longer shocking. They are simply financial inconveniences or disappointments that can be solved.
Over the next few weeks, we’ll be publishing articles about each of the six common financial shocks studied by PEW Charitable Trust. Here is a list of the articles that have come out so far:
Photo by Fabian Blank on Unsplash