Question: An issue between my wife and me is how we should invest our "rainy-day" savings of two to three months' salary. Most financial planners recommend keeping this in money market funds so you will be sure not to lose it, and my wife agrees. But if we invested in a diversified mutual fund such as the Vanguard Index 500, we risk losing only about 20 percent in a very bad year -- or 30 percent over several very bad years -- and have a much better average return. So why not set aside an extra 25 percent or so to cover potential losses and invest for a better return?
Answer: Where on Earth did you get the idea you could lose only 20 percent to 30 percent in the stock market? Good heavens, man, read your history.
That doesn't mean we should bail out of stocks, especially if you're a long-term investor. It does mean we should use some common sense about gambling with "rainy-day" money that you might need in a hurry.
People who don't have an adequate liquid emergency fund find themselves running from one financial crisis to the next. If they have stocks, they're often reluctant to sell, either because they'll have to pay taxes on their winners or have to admit a mistake with their losers. Typically, they put unexpected expenses on credit cards, which means they wind up paying interest rather than earning it. That just adds to the financial stress.
An emergency fund should be kept somewhere safe and liquid, where you don't have to worry about plummeting values or about taking a tax hit just because you need money to fix your roof -- and a money market fund certainly fits that description.
Brainerd Dispatch ©2013. All Rights Reserved.