Editor’s Note: We’d like to welcome our newest guest author, the talented personal finance, money management, and investing writer Roger Raby. Roger writes the blog, The Amateur Financier, and will be contributing monthly articles to Cash Flow Sherpas.
You’ve managed to build up a healthy, three-twelve month emergency fund, enough money to cover you in a variety of adverse situations and give you a reasonable fallback. Good for you! Many people never get to this point, and here you are, with a healthy amount of money just waiting to help you out of any jam. You’ve beaten a big personal finance challenge: devoting yourself to setting aside money to cover you in emergencies.
But now, you’re facing a new challenge: keeping from spending or investing this money. You have a substantial pile, likely thousands or tens of thousands of dollars, just sitting in the bank, earning little interest. (Especially now, with even high interest accounts providing less than 2% interest.) One of the biggest risks to your emergency fund is that you won’t be able to resist the desire to invest it in a more profitable investment, or that you’ll end up simply spending it. Either one could have the unfortunate side effect of leaving you without money in your fund right at the time when you most need it.
How can you make sure that your money will still be there when you need it? Tempting as it would be to depend on your own ability to avoid spending it, having the will power to do so is not always easy. Much like resisting a freshly baked chocolate cake, it’s easier said than done. Instead, try these steps to make it much harder for you empty your emergency fund, even if that’s what you want:
1) Diversify: Just like diversifying your investments makes it harder for any one type of investment to sink your portfolio, diversifying your emergency fund makes it harder for you to empty the fund all at once. Keeping your money in three or four different places will add to the headaches of trying to get to the money, so you’ll be more likely to wait until you have a real emergency in order to do so. As for where to keep the money…
2) Make Your Money Harder to Reach: The more work and longer the period time you need to get to your emergency fund money, the greater chance you’ll be able to resist using it for impulse purchases. While keeping part of your emergency fund in cash is a decent idea (just in case you need some money immediately for a real emergency), having it harder to access places, like savings accounts or CDs, makes it harder to pull the money out on impulse.
3) Invest Some of Your Emergency Fund (Carefully): If your problem is wanting to invest some of your emergency fund money to increase your returns, you might be able to indulge your desire to some extent. Two big things to keep in mind: first, you need to make sure that your investments are very low risk; think high quality short term bond fund, not stocks or stock mutual funds. Second, you can’t put all your money into these types of investments; you should keep a few months of money in cash and other completely safe investments, so you can allow these investments the chance to recover if there is a short term decline.
If you put all of these suggestions together, a pretty good plan to arrange your emergency fund starts to emerge. You can layer your emergency fund in various investment types, building up in terms of potential returns and difficulty of access. A good plan might look like:
-A few hundred dollars in cash, to cover immediate, relatively small emergencies
-A month’s worth of expenses in a local bank, in checking/savings account, to cover larger emergencies
-Another few months of expenses in a high yield online account, earning higher amounts of interest but taking some time to access
-Perhaps a few more months worth of emergency fund money in a different high yield account, to lessen the temptation to empty your account
-Once you have a healthy sized amount in these accounts (at less four-six months’ worth of your expenses), then consider higher yielding (but still relatively safe) investments like short term bond funds
When you have this type of emergency fund in place, you can put money into the system and push it up the level of risk (putting excess cash into your local bank account, transferring that money into an online account, and investing that money into safe mutual funds). If you do have an emergency, it’s easy to start pulling out the money, using the higher yield accounts to replenish your supply of cash on hand.
In any event, good luck keeping your emergency fund well-stocked and ready to serve in case of an emergency!
