It's been wonderful opening our brokerage statements and seeing positive returns again. But don't be deceived by the stock market's recent surge: A good chunk of your net worth should still be in cash.
The amount you should squirrel away in safe, liquid investments is ultimately a personal decision (just like whether you should dye your hair, marry the boring investment banker or the sparkly English teacher, or choose butter over margarine). However, we certainly can provide some Foolish guidelines. How much you set aside depends on the following factors:
1. Your willingness to take risk. Some folks are comfortable with five years' worth of planned, major expenses in a safe, stable account. Others are more conservative, taking a seven-year view. Risk-tolerant investors may have more faith in the stock market, keeping just three years' worth of big-ticket expenses in a short-term savings account and putting the rest in stocks. How much volatility can you withstand? How will you react if you're 63 years old and your 401(k) drops 30% (as many did over the past few years)? How confident are you in your equity investments? Your answers to these types of questions will help you determine the amount you should have in short-term savings.
2. Your needs. Three to six months' of living expenses set aside for emergencies should be a given. This will cover your expenses in the case of temporary unemployment or disability. (When it comes to disability, it's just as important to have enough insurance.) Also consider big-ticket bills coming up, such as the auto insurance bill, and a maintenance slush fund to cover an exploding engine or flooded family room. These funds should be safe and easily accessible.
A final consideration is your number of dependents. If you're responsible for just you and your pet Gila Monster Gilligan, then you can be a little looser with the emergency fund. However, if you're responsible for a passel, horde, or tribe, then you should shoot for six months' worth of expenses, at the very least. The more people directly involved in your financial well-being, the greater chance you'll encounter unanticipated expenses.
3. Your upcoming expenses. Think of the expenses you must pay for from savings (not wages) over the next few years. Have you set aside money for that trip to the Great Barrier Reef you are planning to take in two years? How about the down payment for that new car or house? Will you need tuition for the child(ren)'s education? Are you getting married and paying for the honeymoon and/or the wedding reception?
Let's look at examples of how some folks established their level of short-term savings.
Wanted: Savings plan for SWM
Meet Cliff, who is single and carefree. He can't think far enough ahead to plan tonight's dinner, let alone what major cash needs he will have over the next few years. He isn't planning on buying a car or a home, and he isn't planning on getting married. Of course, those things might happen, but he's not going to worry about them now. He will take a vacation or two, but he'll either charge those on his credit card or pay for them out of any cash available at that time. As for an emergency fund, he figures the only thing he might encounter is the loss of his job. In that event, he intends to move home at mommy and daddy's expense until he lands another job. Thus, he sees no need to set aside cash for emergencies.
What will happen if Cliff is wrong? Here are some possibilities: 1) Cliff will banish himself to the debt dungeon, working for years to get himself out; 2) if he's been contributing to retirement accounts, he may have to withdraw those funds, pay taxes and penalties, and shortchange his future; 2) Cliff's parents will disown him.
Prudent preparations
Now let's meet Prudence, who is also single. Unlike Cliff, she believes in independence; she doesn't want to sponge off her folks or go into debt if the unthinkable happens. She intends to put aside enough cash to cover her spending for three months just in case she loses her job or can't work. That amount comes to $4,500. Since she has no dependents and is well-insured, this is probably enough. Prudence also wants to buy her first car in two years, and will make a down payment of $5,000 when she makes that purchase. She anticipates no other major expenditures in the next three to seven years. Prudence, then, has a short-term savings need of $9,500.
Saving for two... or more
Josh and Millicent have monthly expenses after taxes of $3,000. They want a six-month emergency fund of $18,000 to cover those expenses. Next year Josh and Millicent will take that Bermuda cruise they saw advertised for a cost of $2,800 per couple. They also intend to buy a new car in four years. After trade-in, they estimate they must pay another $15,000 for the car because they do not wish to finance any part of the purchase. Lastly, their eldest son will start college in five years, and they want to set aside enough to pay for the first two years at $4,800 per year. Based on their situation, Josh and Millicent have a short-term savings need of $45,400.
Note that we didn't account for inflation adjustments to the short-term savings estimates. Why? Because those savings will earn interest. It's reasonable to assume that short-term investments -- if chosen properly, and under normal economic conditions -- will return at least the rate of inflation. The only item listed above that might not be covered on an inflation-adjusted basis is college tuition. To be safe, Josh and Millicent could bump up their education savings.
You should evaluate your short-term savings needs at least once a year because your goals and circumstances will change. Some near-term expenses will be paid or eliminated, and new ones will be added. And your daughter Prudence might marry Cliff, which would call for serious financial planning, and perhaps marriage counseling.
Learn much more about your short-term savings options in our Savings Center, which also features some special interest rates for Fools.
