Investing Prerequisite #2: Expanded Emergency Fund

Photo by: Dumbledad

This post is step 2 in our Investing Template.

Many people will debate the details and priority of this, but quite simply there is no reason to begin investing until you have enough liquid cash to survive for a reasonable period.  Unfortunately, this can mean different things to different people.

What Kind of Survival?

One pivotal question in figuring out how big this fund should be is how you would like to live during a financial emergency.  Suppose, for example, that you lose your job; are you comfortable cutting expenses severely so that you can keep more money in better investments?  The stress of finding a new job may be enough on its own without deprivation to boot.

Additionally, you need to really think about which expenses are necessary.  While you don’t want to keep too little in your fund, you don’t want to keep too much either.  This is an emergency fund, so you don’t necessarily have to keep every element of your current lifestyle during this emergency.  You can probably eat out less and see fewer movies, but would want to keep enough funds to pay for your kids’ private school.  Use a budget (you do have one, right?) to get a real idea of what you would need per month to survive and what you want that survival to look like.

What Is A Reasonable Period?

Once you know how much per month it takes you to live, the next question is how long you would reasonably need to live this way.  While some people advocate fairly small emergency funds, it is often desirable to put away enough money to live for a considerable amount of time.  If you lose your job, you don’t want to be forced into taking an inferior job, or cash out investments prematurely, simply because your money is running out.  You may have a realistic idea of how long it would take you to find a job, but I say be very pessimistic when enacting your emergency fund.  I believe 3 months living expenses is a minimum. This is only my personal opinion, but I think giving up potential investment returns is well worth the security this extra time buys.

What is Liquid?

Liquidity is a measure of how quickly you can get the cash.  The most liquid accounts are savings accounts or money market accounts.  Accounts where you can either write a check against it, or get the money into a checking account within hours, not days.  Generally however, liquidity comes with a price.  The more liquid an asset, the worse the returns typically are.  Certificates of Deposit (CDs) for example, offer better returns generally, but require you to leave the money on deposit.  This may sound like a deal breaker, however an ideal solution can involve CDs.

CD Ladder

For those who wish to have a large emergency fund, but don’t want to earn terrible returns on the money, a CD ladder may be an ideal solution.  A CD ladder is a series of CDs that mature often enough that you can use them as your emergency fund.  For example, you might go every month and open a 6 month CD with enough to live on for one month.  If you did this every month for 6 months you would now have a CD ladder.  Every month a CD will mature with enough for you to live on for that month.  If you need that money, retrieve it and don’t allow the CD to renew. If you don’t need the money, leave it there and allow it to compound.  There are many tricks and optimizations for starting a CD ladder, but it can be an optimal way to build your emergency fund.

Now that you’ve eliminated your debts and created your emergency fund you are ready to start making more intricate decisions for your investment strategy.

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