cash to meet unexpected expenses makes good financial sense. If you have
a sister who works on Wall Street as an investment banker or a wealthy and
understanding parent, you can use one of them as your emergency reserve.
(Although you should ask them how they feel about that before you count on
receiving funding from them!) If you don’t have a wealthy family member, the
ball’s in your court to establish a reserve.
Should you invest emergency money in stocks?
As interest rates drifted lower during the 1990s,
keeping emergency money in money market
accounts became less and less rewarding.
When interest rates were 8 or 10 percent,
fewer people questioned the wisdom of an
emergency reserve. However, in the late 1990s,
which had low money market interest rates and
stock market returns of 20 percent per year,
more investors balked at the idea of keeping a
low-interest stash of cash.
I began seeing articles that suggested you
simply keep your emergency reserve in stocks.
After all, you can easily sell stocks (especially
those of larger companies) any day the financial markets are open. Why not treat yourself to
the 20 percent annual returns that stock market
investors enjoyed during the 1990s rather than
earning a paltry few percent?
Stocks can drop and have dropped 20, 30, or
50 percent or more over relatively short periods of time. Consider what happened to stock
prices in the early 2000s and then again in the
late 2000s. Suppose that such a drop coincides
with an emergency — such as the loss of your
job, major medical bills, and so on. Your situation may force you to sell at a loss, perhaps a
substantial one.
Here’s another reason not to keep emergency
money in stocks: If your stocks appreciate and
you need to sell some of them for emergency
cash, you get stuck paying taxes on your gains.
I suggest that you invest your emergency
money in stocks (ideally through well-diversified mutual funds) only if you have a relative
or some other resource to tap for money in
an emergency. Having a backup resource for
money minimizes your need to sell your stock
holdings on short notice. As I discuss in Chapter
5, stocks are intended to be a longer-term
investment, not an investment that you expect
(or need) to sell in the near future.
Make sure you have quick access to at least three months’ to as much as six
months’ worth of living expenses. Keep this emergency money in a money
market fund. You may also be able to borrow against your
employer-based retirement account or against your home equity should you
find yourself in a bind, but these options are much less desirable.
If you don’t have a financial safety net, you may be forced into selling an
investment that you’ve worked hard for. And selling some investments,
such as real estate, costs big money (because of transaction costs, taxes,
and so on).
Consider the case of Warren, who owned his home and rented an investment
property in the Pacific Northwest. He felt, and appeared to be, financially successful. But then Warren lost his job, accumulated sizable medical expenses, in Order before You Invest
and had to sell his investment property to come up with cash for living
expenses. Warren didn’t have enough equity in his home to borrow. He didn’t
have other sources — a wealthy relative, for example — to borrow from
either, so he was stuck selling his investment property. Warren wasn’t able
to purchase another investment property and missed out on the large appreciation the property earned over the subsequent two decades. Between the
costs of selling and taxes, getting rid of the investment property cost Warren
about 15 percent of its sales price. Ouch!
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