Q: I have a fair amount of money set aside for unexpected expenses. Should I put it in a S&P 500 index fund or some other sort of investment vehicle? The way I see it, I can always sell shares if I need the money, and this way I could start earning some returns on my money.
Investing your emergency fund in the stock market would make sense if you knew you weren't going to have any unexpected expenses for at least a few years. However, they call them "unexpected" expenses for a reason.
Here's why investing in the stock market with your emergency fund is a bad idea. Let's say that you have enough money to last for three months if you were to lose your job. You put the money in an index fund like you described and the market proceeds to crash by 50% over the next six months. Now you're down to just a month and a half of expenses if you were to become unemployed.
In short, while the direction of the stock market will almost certainly be upward over the long run, it's entirely possible to have huge swings in the short term. The point of emergency savings is that they'll be there when you need them, and if you invest the money in the stock market, you simply cannot guarantee that will be the case.
If you want to put your emergency savings to work, there are some excellent online high-yield savings accounts and CDs that pay far more than branch-based banks. And your principal will be protected while you're earning the interest.