You know you need to invest some of your income in stocks, bonds and funds of both, and you do. Yet can you feel safe when Wall Street yo-yos a couple hundred points a day? How much cash do you need at the ready?
Most financial advisors agree that first you need an emergency fund of some six months’ expenses – and more in a down economy. Such emergencies generally mean a job loss or other disruption in your income or a blindsiding expense. This fund helps you pay such bills as your mortgage, utilities and groceries – and you may need more than six months’ expenses if your household relies on one income or you lose a job that’s hard for you to replace.
“This account should only be used in case of emergency,” says Dan Crimmins of Crimmins Wealth Management in Woodcliff Lake, N.J. “We recommend that other expenses such as a vacation or additional household expenses be saved for separately.”
If you haven’t saved this much yet, you’re not alone. Almost one in three Americans have no money put aside for emergencies, according to a recent Bankrate survey. About one in five people sock away enough to cover less than three months of expenses.
To boot, fewer than half of American households can replace a month of income through liquid savings, according to the Pew Charitable Trusts. Low-income families typically have less than two weeks’ income in checking and savings accounts and cash.
The ideal size of your fund depends on such factors as the number of incomes in your household, your earnings from such sources as pensions or investments, your job security, your access to a home equity line of credit and your overall cost of living, according to Sterling Raskie of Blankenship Financial in New Berlin, Ill.
“I like to have an additional six months’ cash set aside,” he says. “Usually, this gives a year buffer not only for emergencies but also for unexpected household items such as a new water heater, roof, vehicle repairs and so on.”
Usefulness of these savings hinges on how fast you can get to the money. The two most familiar accounts to hold liquid funds are savings/checking accounts and brokerage money market accounts. Most Americans use the former, along with credit union accounts, to save, according to Americasaves.org, and auto-deduct savings right from a paycheck.
Though the Federal Deposit Insurance Corp. (FDIC) insures your savings up to $250,000, a general savings or checking account pays about 0.10% to 0.25% yearly. Your other major choice is a money market account from a bank, discount brokerage house or other financial institution. These accounts are liquid and stable – usually invested in bonds and other low-yielding paper. Money markets also pay dismal interest, usually around 1% or less.
“Not going to make much,” Raskie says, “but it’s not supposed to. It’s for liquidity.”
Online savings banks tend to pay slightly more interest than the big banks, but also frequently trim their touted higher introductory interest rates after a few months.
Putting your disaster money in an aggressive stock mutual fund may net you better returns, but your safety net for a dire situation can also shrivel in a market crash or correction – leaving you with little of the money you originally earmarked to fund the account.
One thing's for sure when it comes market volatility and your emergency fund: ignore the noise over in your brokerage account, experts advise.
"If your investments are appropriately allocated for the long term or diversified adequately based on the financial goals you're trying to reach, market volatility should have no influence on the amount you need in your emergency fund," says Mary Beth Storjohann of the financial advisory Workable Wealth in San Diego.
And "your fund is just that, meant for emergencies," she adds. "This is a cash cushion meant to supplement or cover unanticipated expenses. It's not meant for everyday expenses, and in a time of market volatility - which isn't an emergency - its purpose doesn't change."
Another trouble with such long-term investments: they tie up your money unless you pay capital gains taxes or some other financial penalty to withdraw your savings.
Finally, Crimmins recommends separating your non-emergency fund from your regular checking or savings account “to ensure that it remains available if needed. Out of sight,” he says, “equals out of mind.”
“Focus on the need for liquidity or the ability to quickly have the cash without losing money,” Crimmins adds. “Then [you] can invest additional funds in other investment portfolios targeting longer-term goals, including preparing for retirement, saving for college or building a legacy account.”
Retirees are, however, one group that might benefit from dipping into an emergency fund amid market whipsawing. “Having the emergency fund to pull from during market volatility prevents you from dipping into your retirement accounts when markets are down and falling prey to negative compounding, realizing a loss by taking a distribution from an IRA or 401(k) during a time when the balance may be down due to market volatility,” Raskie says.