THERE ARE TWO REASONS to hold cash investments: to cover upcoming spending and in case we’re hit with a financial emergency.
Suppose you plan to make a house down payment in the next five years or you’re five years from making your teenager’s first college tuition payment. You don’t want to see this money devoured by a stock or bond market decline, so you probably shouldn’t own anything more adventurous than a high-quality short-term bond fund. Even a short-term bond fund could suffer a modest loss, so you might favor a high-yield savings account or a low-cost money market fund once you’re within 18 or 24 months of spending the money.
Meanwhile, you may need to tap your emergency fund at short notice, so you should probably stash those dollars in the same sort of investments—savings accounts, money market funds and short-term bond funds. How much rainy-day money should you have? One rule of thumb says your emergency fund should equal three-to-six months of living expenses. That’s potentially a huge sum.
Could you hold less? The biggest financial emergency is losing your job. Ponder how long it might take you to find another job, how much you’d need to cover costs in the meantime and how much money is readily available to you.
For instance, you might hold less than the full six months of living expenses if your job is secure, if it would be easy to find a new job or if your spouse also works. You might also hold a smaller emergency reserve if you have easy access to borrowed money thanks to, say, a home equity line of credit. Ditto if you’ve funded a Roth IRA. You can withdraw your original contributions from a Roth IRA at any time, with no income taxes or penalties owed, provided you don’t touch the account’s investment earnings.
What if you have substantial savings in your taxable account—far more than you could conceivably need for a major home repair or a long period of unemployment? You might take more risk, stashing some of your emergency money in intermediate-term bonds and perhaps even buying stock funds. Think of it like a high deductible on an insurance policy: Yes, if financial markets slide, your taxable account would take a hit—but if you have more than enough to cover a financial emergency, you should still be in decent shape.
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