Where should you put the money? Keep in mind that this is your emergency savings, not your emergency investments. Not a single drop of this money belongs in the stock market, not even in the most well-diversified, dividend-paying blue chip stock fund you can find. During the bull market, many of us were literally using our stock fund accounts as de facto banks. When stocks were consistently returning 20-percent-plus returns a year, cash accounts, with their single-digit yields, looked paltry by comparison. But anyone who “saved” money in Enron stock or even in a broadly diversified S&P 500 fund learned how risky it can be to bank in the market. It’s imperative to match your money with your needs.
The less time you have to work with—that is, the less time there is to make up for losses, should they occur—the more conservative you need to be with your money. Money that you’ll need to tap in a year or two, or sooner, should be put into the most conservative and accessible asset: cash. Money that you won’t need for, say, two to five years, should be allowed to grow. But it should be held in moderately safe securities such as short- and intermediate-term bonds, so there’s little chance that its value will diminish during that period of time.
Money that you won’t need for five years or more should be invested more aggressively, in a combination of stocks, bonds, and perhaps other assets, in order to meet your long-term financial goals and outpace the long-term effects of inflation. Because an emergency could arise tomorrow, an emergency fund, by definition, must be held in an ultrasafe and ultra-short-term account. Though fixed-income investments, or bonds, are inherently safer than stocks, they still aren’t safe enough for emergencies.
Even Treasury bonds, backed by the full faith and credit of the federal government, should be considered investments, not savings. Held in a mutual fund, for instance, government and corporate bonds can easily lose value in the short term. It typically happens when market interest rates spike, as they did in 1994 (see “Mistake 4: Overlooking Risks”). Over time, this risk subsides. But if you need to tap your emergency fund tomorrow, you’ll require an account that offers total principal protection. One option is a bank certificate of deposit, or CD. The problem is, most CDs, which are federally insured, hit you with penalty fees for withdrawing money before the term of the contract expires. And who knows if an emergency might arise before a one- or twoyear CD comes due? (As an alternative, there are so-called penaltyfree CDs that allow customers to withdraw money early, but, as you would expect, they return less than traditional CDs.) Earlywithdrawal fees on traditional CDs vary, depending on the financial institution and the term of the CD. But an early withdrawal would typically cost you three months’ worth of interest income on a one-year CD and up to six months’ interest on a two-year CD.