Note: This article is from J.D. Roth, who founded Get Rich Slowly in 2006. J.D.’s non-financial writing can be found at More Than Money, where he recently wrote about how to retire early.
The first step on the road to financial freedom is to eliminate debt. The second is to save for emergencies. Your emergency fund acts as self-insurance, cushioning you from small disasters.
Life is full of unexpected surprises, many of which cost money — a thief smashes the windshield of your car, your son gets sick, your water heater overflows. When people live paycheck to paycheck without any savings, they’re at the mercy of these small crises. Sometimes a tiny problem becomes a huge one because the victim didn’t prepare for possible trouble.
That’s where the emergency fund comes in. By setting aside $500 or $1,000 to cope with life’s slings and arrows, you alleviate worry that a flat tire or a broken bone might prevent you from doing the things you need to do. And once you’ve saved even more — I keep a $5,000 emergency fund — you might find that you sleep more soundly at night.
Because I believe they’re so important, I’ve written extensively about emergency funds in the past:
How and why to start an emergency fund
Learning to love the emergency fund
A credit card is not an emergency fund
Studies show that those without emergency savings are more likely to accumulate debt. An emergency fund is like cheap insurance. If you have a cash cushion, your financial plans can’t be derailed by a single unexpected event — unless it’s huge.
The opportunity fund
But not everything unexpected is bad. Sometimes life brings us lucky breaks — but these opportunities can still cost money. That’s why it makes sense to also keep a chunk of cash in an “opportunity fund.”
I first learned about opportunity funds from reading about billionaires and business owners. These savvy savers often set aside money specifically to take advantage of unexpected opportunities.
I once read an interview with Mark Cuban, for example, in which he described how a person should handle a windfall. “First, I pay off all my credit card debt and evaluate paying off any other debt I have,” he said. “What I have left I put in the bank.”
Why? “Because then it’s available for when I get a good opportunity. Every five years or so there is a bubble bursting or amazing deals available because of a change in the economy.”
Jim Wang (from the small-business blog microblogger.com) is a strong proponent of opportunity funds. “Missing out on an opportunity is often as bad as being struck by an unexpected expense,” Wang wrote for U.S. News last autumn. “In reality, both funds are important if you want to be financially responsible.”
Although I don’t strictly keep an opportunity fund the way I keep an emergency fund, I do keep enough cash on hand to take advantage of lucky breaks. For example:
When a friend wanted investors for his business, I had money to contribute. I’ve earned a handsome return because I could afford to take a risk.
When I spotted a great deal on a last-minute Alaskan cruise, I was able to book a fun (and relatively cheap) vacation.
When I found a deeply discounted display model at the local warehouse store, I was able to purchase a top-rated television at a bargain price.
Your opportunity fund doesn’t need to be as accessible as your emergency fund, so it’s OK to put the money in mutual funds or certificates of deposit. The fund will start small. But as your financial situation improves, you can contribute more and more to the account. In time, your opportunity fund will become large enough that you can do some truly amazing things — like take time off for a round-the-world trip with your best friend, or quit your job to start your own business, or buy that classic car you’ve always wanted.
Buying freedom
Over the past year, I’ve spoken with dozens of people who have achieved financial independence. These folks have accumulated enough capital that they’re no longer compelled to work for an income (although some choose to work for other motives). Many have remarked that money hasn’t bought them happiness; rather, it’s bought them freedom. When an opportunity arises, they can afford to take advantage of the situation.
This is an important point. Financial freedom isn’t an absolute thing. It’s not like you either have it or you don’t. Financial freedom exists on a continuum.
When you eliminate your debt, you increase your financial freedom.
When you build emergency savings, you increase your financial freedom.
When you boost your savings rate (whether by increasing income or decreasing expenses — or both), you increase your financial freedom.
And so on.
As you progress along the continuum of financial freedom from “enslaved by debt” to “financially independent,” you achieve certain milestones. For instance, you eventually reach a point where you have “Screw-It Money,” a cash cushion large enough that you you could quit your job, if you wanted.
The opportunity fund is another key component of financial freedom.
