Ask most financial experts how to prioritize your savings goals, and you'll probably get the same answer: Build your emergency savings first, and then work on growing your overall net worth. Financial emergencies, from job loss to illness, can happen at any time, and an emergency fund can protect you from financial ruin should you suddenly face huge expenses or prolonged unemployment.
While opinions vary as to how much you need for an emergency fund, most professionals agree that you need enough saved up to cover three to 12 months' worth of expenses. If you're single and don't own a home, then you can probably stick to the lower end and feel financially secure, but if you have children and a house you'd rather not risk losing to foreclosure, then you'd be wise to save extra.
No matter how much you ultimately decide to save in your emergency fund, your instinct will probably be to stick it in the bank and leave it there, as you've been told to do. After all, many experts agree that the role of an emergency fund isn't to earn a big return, but rather to be immediately accessible. As such, they'll insist that the best place for that money is in an FDIC-insured account, where your balance is protected (up to $250,000 of it, anyway).
There's risk in a cash-only approach
Here's the problem, though: When you leave your money in a minimal-interest savings account, its value slowly gets eaten away by inflation. With today's interest rates not even reaching 1%, sticking to a cash-only strategy means limiting your potential for growth to a point that's detrimental. In fact, a study from the Journal of Financial Planning found that leaving an emergency fund to sit in a cash account is more likely than not to reduce wealth over time.
Of course, it's a good idea to keep some of your emergency savings in cash -- just not all of it. Instead, consider stashing your money in a mix of CDs and bonds.
CD and bond ladders
Though CD and bond returns don't tend to be as high as those of stocks, you're better off earning 2% on a five-year CD or bond than you are capping your returns at 0.5% by sticking to a savings account alone. To minimize your risk, "ladder" your CDs and bonds so that their maturity dates are evenly spread out across several years. If your investments come due at different points, you'll have more opportunities to pull out your cash without facing early CD withdrawal penalties or running the risk of having to sell your bonds at a loss.
As a quick example of laddering, let's say you have $20,000 in your emergency fund, $16,000 of which you choose to invest in CDs and bonds. With a laddered approach, you'd divide your money into eight different investments -- four CDs and four different bonds -- each initially worth $2,000. Each bond and CD would have a different maturity date. One bond and CD, for instance, might come due in a year, with the next pair maturing in two years, the third in three years, and the final pair in five years. As long as your various maturity dates are staggered, you'll have access to your money at regular intervals while avoiding the risks of committing to a single interest rate.
Overshoot your target
If you're looking to earn money on your emergency savings while minimizing the worry factor, then figure out your target goal and save even more. Let's say you need $30,000 to cover six months' worth of expenses. Make it $40,000 instead, and you'll have a nice little cushion in the event you need money when, say, the bond market is down and you can't wait out those maturity dates. If your emergency account is nicely overfunded, you could even try your hand at the stock market, but if you do, limit yourself to no more than 30% of your assets. This way, if you happen to need money at the precise moment the stock market tanks, the majority of your emergency savings will be accessible while you wait for things to rebound.
While the idea of investing your emergency dollars may give you the jitters, the key is to strike that ideal balance between keeping up with inflation and minimizing your chances of losing principal. Divvy up your investments wisely, and you'll sleep well at night knowing that your money will be there for you when you need it the most.