In your investment policy statement, you might have specific short-term savings goals, such as building up an emergency fund. Savings and investment goals with shorter time horizons require a different approach than your long-term retirement account.
An emergency fund is important for making sure you will be able to pay for regular expenses such as groceries, housing, gas, and/or medicine, in the event of unforeseen circumstances. Emergency funds should generally equal at least 3-6 months worth of your regular expenses, although the amount will depend on your individual circumstances. For example, someone with four children, or a medical condition that could involve unforeseen medical expenses, may wish to build up a larger rainy day fund that can cover 12 or more months of expenses. The stability of your job should also inform the amount you choose, as people working in cyclical fields with a greater likelihood of lay-offs should maintain a larger emergency fund.
In your emergency fund, your goal is to limit the loss of purchasing power from inflation while avoiding assets that experience regular draw-downs, such as stocks. A regular checking or savings account is unlikely to have a high enough yield to avoid losing money from inflation, so you should look for assets or savings accounts that yield at least between 1.5 and 2 percent (if inflation increases, you may need to increase this target). High-yield savings accounts, money market accounts, short-term (3-6 months) U.S. treasury securities, and/or certificates of deposit are your best bets for emergency funds.
For short-term savings goals outside of your emergency fund, the time horizon and your tolerance of risk (based on the importance of the goal) will inform which assets you choose. For example, if your goal is to save enough money over 3-5 years to purchase outright a luxury item, such as car or boat, you may be willing to take on more risk and allocate some funding to stocks or higher-yielding bonds, since a large draw-down in the account shouldn’t impact your ability to cover basic expenses (i.e. you can live without a goat). Conversely, if your goal is to save up for an engagement ring or a wedding, you may not feel comfortable risking your principal with more volatile assets. Telling your spouse you had to buy a cheaper ring or a smaller wedding because you lost 50% in a bear market may not go over well!
Investors can also take the simple approach of matching the time horizon of your goal with the average maturity date of the debt you are purchasing. In other words, if you have a 1-year savings goal, you could choose to put your money in one-year U.S. treasuries, an ETF or index funds with an average maturity date of about 1 year, or one-year certificates of deposit.
- The objective for short-term savings and investments, such as emergency funds, is to protect your principal and maintain your purchasing power.
- For emergency funds, you are NOT looking for high yields and long-term capital appreciation, so you should avoid assets that experience regular significant draw-downs, such as stocks.
- You may wish to keep your emergency fund or short-term savings funds separate from your regular checking account and other brokerage accounts, to help guard against the desire to dip into the fund for non-emergency purposes.