A team at Harvard Business Review tracked every dollar 235 U.S. households spent for a year and found widespread financial vulnerability. Harvard Business Review reported:
Income inequality in the United States is growing, but the most common economic statistics hide a significant portion of Americans’ financial instability by drawing on annual aggregates of income and spending. Annual numbers can hide fluctuations that determine whether families have trouble paying bills or making important investments at a given moment. The lack of access to stable, predictable cash flows is the hard-to-see source of much of today’s economic insecurity…
Our first big finding was that the households’ incomes were highly unstable, even for those with full-time workers. We counted spikes and dips in earning, defined as months in which a household’s income was either 25% more or 25% less than the average. It turned out that households experienced an average of five months per year with either a spike or dip. In other words, incomes were far from average almost half of the time. Income volatility was more extreme for poorer families, but middle class families felt it too…
It doesn’t have to be that way. Volatile income and spending needs are not problems in themselves. When a business, rather than a household, faces such volatility, it responds by building up working capital. Many people can do the equivalent in household terms: They plan, save, rely on family wealth, and use credit and insurance. But the challenge for a growing number of Americans is that they have insufficient ways to cope with the ups and downs. For households, just as for businesses with shaky cash flows, effective ways to cope with the ups and downs are least available to those who need them the most.
The practical way to avoid the financial vulnerability is to maintain an emergency fund. By building up a cash hedge over time, you can borrow from yourself when things go south even if your income is volatile. Having cash on hand can solve a lot of problem. In this way, your emergency fund acts as your insurance.
Once you follow the golden rule of personal finance and live below your means, your savings will increase over time. Having a saving buffer frees you from having to waste time dealing with shortfalls in income or spikes in expenses.