Building an Emergency Fund

An emergency fund isn't just a repository of cash you can dip into when the tires wear out or the dishwasher breaks down. Those emergency dollars can play a critical role in your overall investing strategy.

For example, let's look at two different investors.

Polly Prepared: Spent a few years building an emergency fund, tucking the money away in a savings account and some short-term fixed income securities.

Ivan Impromptu: Has pretty much all his available assets and money tied up in bonds with long-dated maturities and in the stock market.

When a fierce autumn storm blows through town, falling tree branches inflict major damage to both their vehicles. Even after insurance kicks in, each bill is around $1,000.

Polly pays her repair bill by dipping into her emergency fund. Polly's emergency money means she doesn't need to liquidate any of her investments to find the cash. This leaves her investments to continue working to meet her important financial goals.

Because Ivan lacks an emergency fund, he faces the choice of putting the bill on a credit card or selling some stock shares right away— and if the market is down at the moment, he'll be selling at a loss. Neither choice is a strong financial move.

Although credit cards can provide a short-term fix, Ivan will have to pay interest if he carries a balance on his card. Over time, carrying a balance leaves him vulnerable because the monthly interest charges cost money he could be putting toward his financial goals. And, of course, selling stocks at a loss also could hurt Ivan's chances of reaching his long-term financial goals.

Many financial consultants have said the last thing you want is to invest in the markets and then have to dip into your investment portfolio at a loss. If your investment portfolio drops and you don't have an emergency fund, you might panic and sell at the worst possible time.

The lesson? Keeping your emergency money grouped with your long-term investments in the market can throw a wrench into your investment goals. Keeping an emergency fund in safe, liquid assets can keep your investment strategy on track.

Now that it's clear why setting up a separate emergency fund can be critical from an investment standpoint, consider these questions:

• What are the dos and don'ts of getting started?
• How much do I need?
• How can I find the money for an emergency fund while paying for other debt and long-term expenses?

It all starts with budgeting. Identify every monthly expense you have and determine which ones are recurring, fixed, and essential. For most households, that includes:

• Food, shelter, and utilities
• Transportation
• Insurance and health expenses
• Taxes
• Debt payments

Now look at how you can reduce these regular expenses, which can often include some of your biggest spending categories. Think about shopping for more affordable insurance or phone plans. Cutting that kind of household overhead frees up cash each month that can fund your rainy-day account.

Next, look at more discretionary spending, including dining out for meals, entertainment, subscriptions, clothing, and vacations. Determine which expenses are essential and which can be reduced or eliminated. Once you've outlined your expenses, you're ready to determine how much money you have available for savings.

Establish a regular amount to set aside for your emergency fund and arrange to have that money automatically deposited or transferred where you can quickly and easily access the money, such as a certificate of deposit, money market fund, savings account, or short-term fixed income securities.

A savings account won't earn much interest, but it can be one of the safer places to put money. On the other hand, a short-term bond fund, while somewhat less predictable and safe than a savings account, might offer a better chance of creating the snowball effect of compound interest on the original investment. Compound power can grow with time because the money earned in interest begins earning interest as well. One approach is to keep part of your emergency cash in savings and part in a fund.

Some investors set up a separate bank account specifically for emergency funds. Others keep emergency cash as part of their brokerage accounts but keep it segmented so it doesn't get mixed up with investments slated for longer-term goals like retirement.

Nothing is set in stone, but the general rule for emergency savings is three to six months of expenses. Of course, personal lifestyle, career, and income play key roles in how much emergency savings a fund might be able to cover. An immediate goal could be to set aside one month of living expenses as a priority, then increase your emergency savings over time.

If your income is mostly stable, a smaller emergency fund might work. But if your situation is unstable, it could be wise to put as much as a year of expenses aside.

But what about other important priorities, such as paying off college debt, saving for a down payment on a house, and building education and retirement savings? Again, those priorities are all important, but having emergency cash is the key short-term priority, because without it, your longer-term goals could get dinged.

Some financial experts advise clients to put money toward their goals into short-term, intermediate-term, and long-term buckets. The short-term plan includes emergency savings. Intermediate goals may include buying a house and paying for college. A critical long-term goal is retirement. But the longer-term buckets can spring a leak if emergencies aren't covered by short-term funds.

The goal is to set up an emergency fund and have it in place sooner rather than later. Without it, you could be putting all your long-term plans at risk.