You may have heard from speaking with an advisor or by listening to financial news that it is prudent to have an emergency cash reserve. It's probably not shocking to most of us that having some cash on the side to use when unexpected expenses creep up is a good idea. But you may wonder how much is necessary to keep and how to "invest" it.
Most surprise expenses will run in the $100-3,000 range, considering the cost of typical home repairs, auto deductibles, etc. But depending on your personal situation, additional risk could exist from job instability, inconsistent income, or even becoming disabled. In reality, we're all at risk of disability!
So in order to calculate the amount needed for your emergency reserve, consider adding up your mandatory monthly expenses and multiplying by the number of months you feel might equate to your risk level. Start with a minimum of three months. Then add on additional months based on your tolerance for risk and personal situation. Self-employed individuals may want to consider additional months if income is fairly inconsistent or unstable. You may also want to match the number of months to the waiting period on your disability insurance. Check with your insurance specialist to learn the facts about your coverage.
Once you determine the amount you need to have, you must decide what to do with it. The ability to avoid the forced sale of investments in an emergency situation is a key element to successful cash management. When the water heater breaks or you get in a "fender bender" you want to have enough cash available to pay these expenses. You can't time when financial problems might pop up, so it's very possible the market could be in a slump when you need access to cash. The last thing you want to do is sell stock when the market is down just to pay the bills.
Therefore, the amount you keep in your emergency cash reserve should be kept in just that ... cash. In other words, outside of markets that tend to have some sort of volatility risk to principal. Ideal places to hold your emergency money would be a high-interest savings account, money market account, or short-term CDs. Be willing to research multiple banks or money managers for your cash. Too often, people will build their emergency cash in the savings account at the place they do their primary banking. Eventually, it is pointed out to them that the interest rate offered by the bank giants can be as low as 0.05%!
Finally, don't feel as though you have to reach your total emergency cash reserve figure overnight. Once you know your target for cash, save toward it like you do all your financial goals. Develop a plan to systematically save to your account on a bi-weekly or monthly basis. As always, if you need assistance determining the right amount of cash to have or developing a plan to save, work with a financial advisor to help you see it through.