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An Emergency Fund (EF) is a savings account set up to pool and hold a minimum of three months of calculated Non-Discretionary Income (NDI). An EF captures a minimum of three months of Non-Discretionary Income (NDI). What is NDI? These are expenses incurred that must be settled irrespective of income. For instance, rent must be paid, groceries must be paid, we cannot simply stop paying utility bills because we lost our job and thus income.
The first thing to do is to list out all expenses you will incur and attach a cost to them per month or annual basis but corresponding to the period of payment. You do this to identify the necessary expenses which we refer to as the NDE.
Next, decide which of the expenses in your list are Non-Discretionary. In other words, which of these expenses must be settled irrespective of income?
The Emergency Fund is simply a piggy bank. Once it is set up, you can increase the minimum savings as high as you want to go. An EF is not only for downturns, but also good for opportunities.
It is best to keep your Emergency Funds in cash or near cash investments. WHY? Because the Return on investment for the EF is secondary to access to those savings. Also, you want your EF in an investment class with fixed income with no variation in returns. Practically, do not invest your EF portfolio in equities that pay a variable return or even any asset which may need documentation and visits before you can access your funds.
So, if there is income interruption due to job loss or you simply want to take a long holiday and write a book, you can do so and still meet your expenses from these savings.
