For individual investors, one of the most important lessons of the COVID-19 crisis has been to save for a rainy day. Of course, having a rainy day fund has always been a foundation of financial health, but there’s nothing like a pandemic to really drive the lesson home.
Why Do I Need a Rainy Day Fund?
Having a financial cushion to pay important bills and buy necessities may be the only way to get through uncertain times and a tough job market. Although achieving this may require discipline and a sound financial and investment plan, being prepared is more than worth the trouble.
How Much Money Should I Save?
Many personal finance experts suggest having three, six, or as much as twelve months’ worth of savings. This is so that when times get tough, you’ll be able to count on having enough funds to meet your needs until the situation calms. While it may be difficult to save up in normal times, you may thank yourself later for having the foresight to do so. We have some tips on spending less that might help you set money aside more easily.
However, if you haven’t saved as much as is recommended, you’re not alone. Historically, American households tend to save only about 6.6% of their disposable incomes (i.e., their incomes after paying for basic necessities). While this is certainly better than not saving at all, it’s also clearly not enough. This savings rate means that over the course of 12 months, the average American family only saves enough to cover 3 weeks of expenses in an emergency. At this rate, it would take about 15 years to save up enough to pay one year’s worth of expenses.
Chart: Americans historically save an average of 6.6% of their household incomes. This number jumped when the economy was shut down.
Sources: Clearnomics, Bureau of Economic Analysis
COVID-19 Affected America’s Savings Rate
The savings rate, however, did jump during the recent crisis when most of the country was shut down, rising to as high as 33%. This shows that Americans are able to save when necessary – or when they are forced to do so. The savings rate is now settling back to previous levels as businesses open up and Americans begin to open their wallets again.
Having a financial cushion is also more important when the job market is uncertain. At the moment, there are still over 18 million Americans collecting unemployment benefits each week – a number that peaked around 25 million in May. While this number is improving at the moment, many Americans have been furloughed for months at this point. Thus, while having three months of savings may be the recommended minimum, clearly more is better if it is possible.
The amount of savings you have isn’t the only critical factor – preserving the value of your savings matters too. Every year, inflation eats away at the purchasing power of your hard-earned money. In other words, if inflation is 2% per year, then $100 of savings can really only buy $98 worth of goods after one year, $96 the next year, $92 the third year, and so on.
Chart: Estimated interest income from certificates of deposit (CDs) – with and without inflation. Due to low interest rates, even moderate inflation has eroded the value of savings over the past ten years.
Sources: Clearnomics, FDIC
The Best Way to Save Money
The best way to combat this erosion is by generating interest and returns on your savings. While this can be done through a basic savings account, investing in assets such as Treasuries and other bonds, such as through higher-quality ETFs, may generate higher levels of income. Since the 2008 financial crisis, with interest rates so low, even a moderate level of inflation has managed to erode the value of savings. Thus, you’ll need to do more to protect and even grow your hard-won savings.
Thus, the recent crisis underscores the need to save for the future. This can be challenging even in good times, but you’ll thank yourself when times are tough and the job market is uncertain. Additionally, it’s just as important to make sure that the value of your savings is preserved by having a sound financial and investment plan.