I recently read The Psychology of Money by Morgan Housel – A great book, full of great advice. One of the pieces of advice that popped out to me was about the importance of cash. It’s such a basic thing, and while I have heard about it before, I wasn’t following it.
Building your Emergency Fund is a prerequisite for investing, according to the flowchart from r/UKPersonalFinance – it even comes up twice! (step #2 and step #5). Yet, I failed to build up one while roughly following everything else. Why is that?
Me: “Why bother building such a large emergency fund? During an emergency, I can just sell my stocks to deal with it, right?”
I treated my investment and cash as interchangeable, and that’s exactly the kind of thinking that misses the forest for the trees. Turns out that dealing with emergencies was only half the goal of the Emergency Fund.
Here are the excerpts from the book that highlight the missed forest lesson:
No one wants to hold cash during a bull market. They want to own assets that go up a lot. You look and feel conservative holding cash during a bull market, because you become acutely aware of how much return you’re giving up by not owning the good stuff.
Say cash earns 1% and stocks return 10% a year. That 9% gap will gnaw at you every day.
But if that cash prevents you from having to sell your stocks during a bear market, the actual return you earned on that cash is not 1% a year—it could be many multiples of that, because preventing one desperate, ill-timed stock sale can do more for your lifetime returns than picking dozens of big-time winners.
So, an Emergency Fund of cash has two purposes:
- Dealing with the imminent emergency.
- Ensuring we don’t have to dip into our investments when doing #1.
Investment and cash are not interchangeable. Investment can go down and if emergency hits at a bad time, I could wipe out a lot of progress already made.
First rule of compounding: Never interrupt it unnecessarily.
Charlie Munger
Instead of thinking of cash as a lost opportunity, think it’s a buffer that prevents unnecessary interruptions.