The amount you 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 can offer some guidelines that may color your decision.
How much you set aside depends on the following factors:
- Your willingness to take risk.
- Your needs.
- Your upcoming expenses.
Consider the following scenarios:
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; (3) Cliff's parents will disown him.
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.