The emergency fund is a liquidity buffer designed to cover unexpected expenses. It represents the third level of the financial needs pyramid.

Anyone who talks about financial planning considers the emergency fund an essential tool for managing unforeseen costs. No matter how good you think you are at planning, there will always be a moment when your car breaks down, the dishwasher stops working, or the boiler fails — and, unfortunately, 99% of the time these events seem to happen all at once.

The emergency fund can therefore be seen as a form of self-insurance — a reserve that should only be used in genuine emergencies.

For ordinary or recurring expenses (rent or mortgage, car payments, groceries, utility bills, and so on), it is important to keep sufficient liquidity in your checking account.

How Large Should an Emergency Fund Be?

The standard recommendation is to set aside between 6 and 9 months of expenses, depending on what makes you feel more secure.

For example, if a household’s monthly expenses amount to €3,000, the emergency fund should range between €18,000 and €27,000.

There is nothing preventing you from increasing or decreasing this buffer (from 3 months up to even 24 months), but there are specific variables that may require a more conservative allocation.

1. Type of Employment and Income Stability

The first variable to consider is the nature of your job and the regularity of your cash flows.

An employee contract generally provides more security and legal protection than self-employment. If your job is seasonal, this must also be taken into account to cover periods when you are not working or working less. During those times, your cash flow will be affected.

2. Household Dependents

The second variable is how many people depend on your income relative to how many earn.

Being the sole income earner in a family of four requires a larger emergency fund. In the event of job loss, you need sufficient time to find new employment without risking being unable to cover basic living expenses.

3. Financial Safety Net

The third factor is what can be defined as your financial safety network.

If you have relatives or friends willing and able to support you in case of emergency, you may reduce the size of your fund. Of course, this depends entirely on the strength and reliability of those relationships.

What the Emergency Fund Should Not Cover

An emergency fund is not meant for ordinary, recurring, or well-planned expenses.

For example, after careful consideration, you decide to replace your car in two years. You should save specifically for that goal over the next two years and avoid touching the emergency fund. However, if the car unexpectedly breaks down in six months, then it is appropriate to use the emergency fund. That is its purpose.

Another category the emergency fund should not cover includes events with potentially catastrophic financial consequences for which insurance exists.

Civil liability, home insurance, life insurance, or permanent disability coverage (especially if you are the sole income provider) all fall into this category.

These are what Nassim Taleb calls “asymmetric risks” — events where the potential loss is infinitely greater than the savings generated by not insuring against them.

Failing to protect yourself against these risks would be irrational — much like refusing to wear a seatbelt while driving.

Should You Invest Your Emergency Fund?

Let’s start from a basic premise: the primary purpose of an emergency fund is protection, not return generation.

However, given the size such a fund can reach, a psychological mechanism often kicks in — FOMO (Fear of Missing Out).

Your brain convinces you that if something happens, you will have time to liquidate investments if needed. Meanwhile, seeing a significant amount of cash sitting idle can feel frustrating.

This feeling is even stronger when the ratio between your emergency fund and your long-term invested capital is high.

For example, if you have just started saving and have recently built (or are close to completing) your emergency fund, you may find yourself with €10,000–€20,000 sitting in cash and little or nothing invested for the long term.

The temptation is to change your plan midway — to take part of the emergency fund and invest it.

Nothing could be more wrong.

As shown in the financial needs pyramid, first you protect the present, then you invest for the future.

First you secure insurance coverage, ensure stable cash flows (and pay off high-interest debt), and build your emergency fund. Only afterward do you focus on long-term investments.

Splitting resources prematurely increases risk.

That said, investing emergency funds has become more attractive in recent months due to rising interest rates. Between 2015 and 2021, when rates were near zero, keeping the emergency fund in a checking account was a reasonable option, as risk-free instruments yielded nothing.

How to Invest the Emergency Fund

After clarifying that the purpose of an emergency fund is protection — not return generation — investing it is only reasonable if the chosen instrument is easily accessible and quickly liquidated.

The best tools available are mainly three:

• An instant-access savings account
• An ultra short-term bond fund
• A synthetic money market fund

The order is intentional. We start with the simplest instrument to understand and move toward the more complex one.

Instant-Access Savings Account

A savings account is a banking product designed as a capital preservation tool — essentially a savings container.

The bank pays interest on the deposited capital because it uses that capital to finance other activities. An instant-access account will pay lower interest than a fixed-term account, since the bank does not know when you will withdraw your funds.

Savings accounts are often offered by smaller banks. This represents a limited risk, because in case of bank failure, deposit guarantee schemes protect savers up to €100,000 per institution. For larger amounts, it is prudent to diversify across multiple banks to reduce concentration risk.

Interest earned on savings accounts is typically taxed (in many jurisdictions around 26%, though this varies by country). In addition, there may be a wealth tax or stamp duty applied to the total balance, depending on local regulations.

Ranking the “best” savings accounts is pointless, as offers change continuously.

Ultra Short-Term Bond Fund

An ultra short-term bond fund is an instrument that invests exclusively in very short-term fixed-income securities.

The average duration of the bonds held in the fund is usually less than one year. Currency hedging is generally not applied, and the securities in the portfolio typically carry an investment-grade rating.

Note: Duration represents the time required for a bond to repay the initially invested capital. It is expressed in days or years.

My suggestion is to invest in ultra short-term government bond funds denominated in local currency.

Government bonds carry lower risk compared to corporate bonds.
Local currency is preferable because investing in foreign currency introduces exchange rate risk, increasing the volatility of an instrument that should ideally have near-zero volatility.

A Point of Attention on Bond Funds

A bond fund operates by purchasing bonds from various issuers according to its mandate.

For example, a European government liquidity fund will invest exclusively in short-dated government bonds from Eurozone countries that meet specific rating requirements imposed by regulatory authorities.

The bonds purchased can vary significantly. The fund may hold thirty-year government bonds with less than one year remaining to maturity. Moreover, to maintain a constant duration, the fund manager may sell bonds before their actual maturity.

In the current environment, this can be an advantage. The fund automatically adjusts to new interest rate levels set by central banks by selling bonds issued at lower rates and purchasing newly issued bonds offering higher yields.

However, in a declining interest rate environment, this mechanism becomes a double-edged sword. By not holding bonds to maturity in order to maintain duration, the fund may sell them at a loss relative to their purchase price.

These instruments are suitable for an emergency fund because the price variation of a bond fund is a function of its average duration.

This means that if central bank interest rates decrease by 1%, a fund with an average duration of six months will experience a price variation of approximately 0.5% of its current value.

Investing in these instruments requires more knowledge and attention compared to a simple savings account.

It should also be considered that in a declining interest rate environment, banks are highly likely to adjust savings account conditions through unilateral contract modifications.

Synthetic Replication Money Market Fund

This category includes funds whose benchmark is the marginal refinancing rate — the rate at which banks lend money to each other for a duration of 24 hours. For this reason, it is also referred to as the overnight rate.

In addition, the benchmark replication method of these products is synthetic (typically swap-based and unfunded).

It is therefore necessary to clarify both aspects: what the interbank overnight rate is in practical terms, and what unfunded synthetic swap-based replication means.

The Interbank Overnight Rate

Banks are required by their respective central banks to maintain a minimum level of liquidity reserves.

During the day, these reserves fluctuate significantly depending on client withdrawals and deposits. At the end of the day, some banks will have excess liquidity, while others will face a deficit and need to refinance.

The banks with surplus liquidity lend to those with shortages. The interest rate at which banks exchange money on a daily basis is the overnight rate.

The overnight rate moves in relation to changes in interest rates set by central banks. When rates rise, money is said to “cost more.” This dynamic is directly reflected in the interbank overnight rate: the higher the central bank rates, the higher the overnight rate.

This ultimately affects mortgages and loans, as banks pass on this increased cost of funding to end consumers by raising lending rates.

Unfunded Synthetic Swap-Based Replication

A passive ETF operates by replicating an index (its benchmark).

There are three main replication methods:

• Full physical replication
• Sampling replication
• Synthetic replication

Full physical replication means purchasing all securities included in the index. For example, if the benchmark is the S&P 500, a fully physically replicated ETF will buy all 500 stocks in the index.

Sampling replication involves purchasing only a portion of the securities within the benchmark. For instance, the well-known VWCE ETF, which tracks the FTSE All-World index, does not purchase every single stock in the index but only a representative subset. The goal is to closely track index performance while reducing transaction costs.

The third method is synthetic replication.

Synthetic replication does not involve directly purchasing the securities of the benchmark. Instead, it seeks to replicate the index’s performance through derivative contracts.

Synthetic replication can be funded swap-based or unfunded swap-based.

The difference is that funded replication directly enters into a swap contract, while unfunded replication purchases a substitute basket of securities that acts as collateral.

In the case of money market ETFs — which typically use unfunded synthetic replication — the issuer purchases a substitute basket. The return of this substitute basket (adjusted for the swap cost) is exchanged with a counterparty, which in turn delivers the benchmark return of the ETF.

Conclusion

The fact that I dedicated most of this article to the investment aspect of the emergency fund should not encourage you to invest it — if anything, I hope it has the opposite effect.

Precisely because the presence of this fund is far more important than its return, investing it is a delicate decision and must be approached with great caution.

The fundamental point is setting aside a fund that protects you in case of emergency.

Given current yields, I understand that leaving this money sitting idle in a bank account may feel like a waste. That is why I wanted to present alternatives.

Although I have personally chosen to invest these funds in XEON, this does not mean it is the best choice for everyone.

The first step in deciding whether to invest in any instrument is not to look at its return, but to fully understand how it works.

For those who do not want to spend too much time analyzing the details, the optimal solution is, without any doubt, a savings account.

DISCLAIMER
I am not a financial advisor, but an individual investor sharing my personal journey. This article is for educational purposes only. Past performance does not guarantee future returns. Taxes, fees, and investment outcomes may differ from historical data. Carefully consider your personal situation, risk tolerance, and financial goals. If in doubt, consult a qualified professional.