While experts have been warning about the potential for global pandemics for years, the emergence and spread of COVID-19 has been an enormous shock to societal systems. Along with the risk to life and health, many families have have been thrown into economic turmoil. In a world with the potential for social and economic shocks at this magnitude and speed, do we need to reconsider the standard rules of personal finance?
There are two common financial planning guidelines that come to mind when thinking about periods of financial stress. The first is to maintain an emergency fund. The second is to manage household finances so that you can reduce monthly expenses by 30%-50% if you really need to.
The standard advice in financial planning is to maintain an emergency fund of three to six months of living expenses in cash or some other low-risk / highly-liquid form such as short-term government bonds. In recent years, with incredibly low interest rates on CDs, savings accounts, and bonds, more people are investing some or all of their emergency savings in stocks and other risky assets. It seems like a waste to maintain a big pool of low-yield assets when the stock market is going up double digits. As the COVID-19 crisis demonstrates, however, very bad things can happen incredibly quickly. Many people are finding themselves out of work or facing pay cuts at the same time that the stock market is declining. The old-school advice of having three to six months of living expenses in very low-risk assets is serving people well during the COVID-19 shut down. While we don’t know how long we will see elevated unemployment and reduced consumer demands for goods and services, having a six-month buffer is a very valuable hedge.
The well-known 50/30/20 budget is based on categorizing monthly expenses into three categories: 50% requirements, 30% wants, and 20% extra debt payments or savings. Requirements are things like food, rent or mortgage, health insurance, and minimum monthly debt payments. The wants are things that you like but could cut out if you need to. The final category, savings and accelerated debt payments, is where you build wealth. The power of this concept is that you can reduce monthly expenses by as much as 50% if you hit a period of financial difficulty. While limiting your monthly required expenses to half of your income may seem extreme during the good times, this approach could easily make the crucial difference in getting through an extreme dislocation such as COVID-2019.
The tried-and-true planning rules for periods of financial stress look sensible and appropriate in light of COVID-19. One challenge in applying these rules, however is recency bias, which causes people to assign lower probability to events that have not happened for a long time. The longer it has been since an economic crisis, the less people worry about being prepared. During the good times, we start to think that maintaining a substantial emergency fund is overly conservative. Similarly, if our incomes have increased steadily for years, it looks safer to take on higher debt payments. And, of course, the better stocks perform, the more allocation people put into stocks vs. bonds. One of the hallmarks of the late stages of a period of economic growth is tons of articles suggesting that a 100% stock portfolio is the way to go. Simply put, people tend to be less worried about, and prepared for, bad times when they are in the midst of good times. This bias is a large part of what drives economic cycles in the first place.
My conclusion is that classic rules of personal finance pertaining to emergency preparedness look entirely relevant and appropriate in light of COVID-19. I suspect, however, that few families actually follow these rules. Recency bias and fear of missing out on gains in boom times explain part of the situation. The more difficult problem is that maintaining six months of expenses in a savings account and limiting monthly critical expenditures to 50% of income are way beyond reach for most households. More than 40% of Americans say that they could not cover a one-time surprise expense of $1,000. There is a huge gap between this reality and the advice of having three to six months of expenses saved. How many more families could meet or come close to the standard advice for emergency savings or the 50/30/20 budget if they made better choices? That is one big question. The other question is how we, as a society, can help people to be better prepared for bad times. Better financial education is certainly one part of the solution. Another part of the solution is to expand the social safety net. There is no question, however, that individual responsibility has to be a big part of the solution, given that almost 20% of Americans earnings $100,000 or more report that they are living paycheck to paycheck.
Geoff Considine on Finance and Economics 