How Risky is Your Income?

December 15, 2011

In his book “Are You a Stock or a Bond,” finance professor, Moshe Milevsky argues that how we invest should be based on the nature of our job. For example, if you have a safe job with a steady income like a tenured professor, then you are like a bond and you can afford to be more aggressive with your investment portfolio. On the other hand, if you work in an unstable industry or if you have an unstable income like a real estate agent or business owner, then you are like a stock and should be more conservative with your investments.

But why should your job security affect your retirement account? If you lose your job or otherwise need to get through a rough patch, you’d get hit with penalties if you withdrew the money from your retirement plan before you turn 59 ½. On the other hand, Milevsky’s approach makes a lot of sense if we’re talking about how much you should have in emergency cash reserves. After all, they’re meant exactly for situations like that.

When I first started my financial career, I was an investment broker for Edward Jones, where I was compensated mostly by commission. Because of my willingness to take risks (as evidenced by taking a job that only had a small salary for the first year) and my long time horizon until retirement, you might think I would have been aggressive with my money. Instead, I put all of my money into building larger cash reserves to cushion the inevitable months where my income would take a dip. I was relying on my job to provide growth and my savings to provide safety, rather than the other way around. This continued for the next few years as I went from a low salary to no salary at all. This sounds like I was applying Milevsky’s strategy of being conservative because my job was aggressive, but if I had enough in cash reserves, I would have been more aggressive with the remainder of my investments regardless of where I was working.

The other factor to determine how much you need in emergency cash is whether you rely on one income or two. You would think that a two-income household would be safer, but that’s not necessarily the case. What often happens is that a couple will stretch their incomes to have as much of a home, cars, etc. as their combined income can afford. That means if just one of them loses a job, the other won’t be able to pay all the bills. This actually increases their risk because there’s twice as much of a chance that either one of them will lose their job than if they were each just relying on their own income.

Now think about your own job situation. Do you lack a base salary that covers your expenses? How worried are you about layoffs at your workplace? Are you dependent on someone else’s income as well? For each of those questions that you answer yes to, you may want to have 3-4 months of expenses in savings. If you have a base salary in a secured job and only rely on your income, you may only need 3-4 months of expenses in savings. If you work on commission for a company that may go under and rely on your spouse’s income as well, you may want 9-12 months of expenses in savings.

As you can see, the question of how much to have in an emergency fund can be as customized as every other part of financial planning. It all depends on how secure your income is. As professor Milevsky would put it, are you a stock or a bond?