Rules of Thumb .... And How To Have Better Thumbs

Here's some conventional wisdom from the world of personal financial planning. One of your early goals should be to build emergency reserves worth about six times your average monthly expenses. For example, if you usually spend about $3,000 per month, then you aim to build emergency reserves of about $18,000. This amount should be held in cash, not stocks or bonds or something else.

The idea is that if a person suddenly loses his job, he will usually succeed in finding a new one within six months. Thus if his emergency reserves are all nice and ready, then it can adequately sustain and support his usual lifestyle until he finds another job. The reserves should be in cash, because that's the safest, most liquid asset.

Two assumptions here. Firstly, that six months is enough time to find the new job. In more-normal times, this may sound reasonable. But current times are proving to be somewhat extraordinary. So quite arguably, the "six times" figure should be revised upwards, say, to "nine times".

The second assumption is that if you lose your job, you will largely continue to live the way you lived before, and therefore incur roughly the same amount of monthly expenses. In practice, this assumption could turn out to be true in many cases. Why?

Because when a person suddenly loses his job, he may not adapt quickly to the changed circumstances. He may promptly cut back on some smaller, more easily cuttable expenses (for example, eating out less often). However, there will inevitably be psychological resistance to the bigger lifestyle changes (eg giving up the car, or the maid).

Some of this psychological resistance will arise from the person's hope that perhaps he'll find a new job really quickly (eg maybe tomorrow, or next week), and therefore he doesn't really need to make any major lifestyle changes. The hope isn't necessarily unjustifiable or irrational. But it's important to have a Plan B ready, just so you're not unexpectedly caught with your pants down.

The way I see it, the trick to dealing with the psychological resistance is that even when you still have a job, you should start becoming very clear on what you've been spending it on. Then you'll know exactly what you need to cut, if it later turns out that you really do need to cut. Gather the information now, when you still have a calm, clear head. Don't wait till you actually lose your job, by which time you may be too upset and your emotions start getting in the way of rational decision-making.

Right now, do you know how exactly you've been spending your money every month? If you don't, there's a good chance that you're wasting some of it. And let's say, for the sake of discussion, that starting from tomorrow, you have to spend 30% less every month. What decisions would you make, which parts of your lifestyle would you adjust, to immediately bring your expenses down to that level?