"It's the economy, stupid!"
Remember that campaign slogan popularized during the 1992 presidential election? I do. I also remember that the candidate who employed those words won that race. Possibly his campaign's catchphrase had something to do with his victory. I really can't say. But does that matter? The words still endure, possibly because they embody some truth. So let's paraphrase them into a Foolish slogan for today:
"It's the stock market, Fool!"
To me, that one simple sentence says it all. On one hand, it highlights The Motley Fool's preference for stocks as the vehicle of choice for our long-term investments. We believe most strongly that stocks are where we will get the biggest bang for our buck over the long term.
On the other hand, that sentence also recognizes that stock values can and do move violently, both upward and downward, and often with breathtaking speed. A steep decline can be absolutely gut-wrenching. If you had to liquidate some investments to obtain needed funds, would you want to sell stocks during a period when stock prices are falling? Most of us would relish that prospect almost as much as we would enjoy getting a poke in the eye with a sharp stick.
Don't let bears eat your retirement
As we all know, bear markets do happen, and they can last for years. Which is why we believe that no money you will need within the next three to seven years should be invested in stocks. If you're an aggressive investor, then a three-year reserve should remain out of the stock market. If you're a conservative investor, then a seven-year cushion should suffice. I'm partial to a five-year period myself. Once I have a five-year cushion of all the income I will take from savings set aside, my remaining assets are invested in the stock market.
How do you determine how much money you should keep in your safety stash? Look at every short-term expense you know you will pay for from your savings (i.e., not from your job income, pension check, Social Security check, etc.). Then examine your willingness to take a risk in the stock market. You should assume you will keep at least three years' worth of needed savings out of the stock market, but your aversion to taking a risk could increase that amount.Whatever you do, avoid the tendency to make a big drill out of this calculation. Just anticipate what expenses you must pay from savings over the three- to seven-year period. The total of those expenses then becomes the amount you will invest in something other than stocks. And the only thing that really determines whether you will have a three-year or a seven-year level of safety is your ability to sleep soundly at night regardless of what the stock market does. The less you trust stocks, the more you will have in your safety stash.
Cuddle up with your cushion
Invest your safety cushion in anything that meets your comfort level. I like to put my current year's draw into a money market fund until it must be spent. That way, I continue to earn a small return on my funds. For a higher rate of return, I split another four years' income evenly between short-term and mid-term bonds. Some folks use a combination of Treasuries, certificates of deposit, and/or a bond ladder.
There are a number of ways you can handle your short-term investments to ensure they are not in stocks. The method I use is simply one that allows me to sleep comfortably at night. You should select a method that lets you do the same.
So, there you have it, the basics of why to use and how to create a safety level of short-term income. It's definitely not rocket science, just common sense. Once built, the only maintenance required is to review your needs once each year to replenish or increase your safety stash as needed.
And remember -- "It's the stock market, Fool!"