We all want our money working for us. Whether it be purchasing a home, investing in the stock market, or starting a business. The thought of our money simply sitting in a savings account seems to gnaw at most of us.
Maybe it's because people are becoming more accepting of the fact that you simply can't save your way to retirement. Even with investing it's hard enough having a suitable amount of capital when you reach retirement age, let alone trying to simply save your way to that magic number.
However, there is an underlying problem to this strong urge to get your money moving. You will need to invest as well as save, if you are looking to retire one day. But you need to save before you can invest. Talk about a catch 22!
An emergency fund is crucial to a strong investment portfolio
If you're looking to start investing, it's imperative that you have some sort of emergency fund available for those “uh-oh” situations. In order to figure out why, we need to first understand some basics about how the stock market works.
The stock market promises all but guaranteed returns. It is volatile.
In order to benefit from the returns the stock market offers, it's important that you only invest with money you don't plan to touch. Why? It’s a well known fact that the stock market returns on average 7% to it's investors every year. However, this 7% is an average, and not a number you can hope to achieve year over year.
Let's take 4 returns on an investment portfolio as an example:
Year one: +20%
Year two: -35%
Year three: 0%
Year four: +43%
Let's not think about the fact that 3 of 4 of these years would have been an absolute roller coaster of a ride. The important thing to note is the average return over these 4 years is 7%. This should highlight some of the extreme market volatility you can expect to go through investing in the markets, depending on your strategy.
So why are you telling me all of this?
Let's imagine you decide you don't need an emergency fund, and instead open up a brokerage and invest your savings in some stocks. In year one, you're jumping for joy. Your investments have increased 20% and you look like a genius.
Year two, your heart sinks as your investments plummet 35%. But, you've heard about the amazing returns of the stock market and know that everything will return to normal in due time.
In year three, your portfolio returns nothing, but that is far from the most disappointing thing you've experienced this year. Your car broke down, the warranty just ended, and you need a new motor. You need $3000 and you don't have a dime saved.
You've got a credit card, but you know paying 20% interest on the money you need when you have it sitting in your investment account isn't the best way to go about things. You sell your positions, withdraw your money and pay for your new motor.
In the fourth year, with your money pulled out, the stock market surges back with an impressive 43% gain. Awesome! If you left your money alone that is. Instead, you're left with a net loss of 15% from pulling it out after year three.
An emergency fund protects you from this short term volatility
If our investor had instead saved a bit of money up prior to investing, their investments would have reaped the rewards of year four, and they would have been able to pay for the expense in cash.
There is a lot of websites that preach the fact that you don't need an emergency fund prior to investing. As you can see from the situation above, even with it's extreme values, the decision to build up a backup fund is a no brainer.
Selling your investments over a short duration is nothing short of a disaster. Sure, you may get lucky and have to pull them out during a crazy bull market. But, we can't all be that lucky. For some, they will be pulling investments out when the market is abnormally low, which is the time you should be buying, not selling.
So how much should I have saved?
This is a question that I really can't answer. It all depends on your lifestyle and monthly expenses. For example, if you have a brand new vehicle that is still under warranty, budgeting for vehicle repairs may not be needed.
When I started to build my emergency fund, I decided I wanted at least 3 months mortgage and utility payments in the bank, and about $3000 for unplanned expenses.
Obviously the nature of your employment will factor in as to how much of a buffer you will need. If you're in an industry where jobs are scarce and you feel it may be months before you can pick up another job, it may be wise to save a little more.
The easiest way to go about it is to simply take your necessary expenses per month, and multiply that by a number you would be comfortable with. Some people may think that 1 month is enough, whereas some may think 6 is necessary. Notice I highlighted necessary. By all means, if you'd like, assign a dollar amount to unneeded expenses like eating out, going to the movies and buying liquor.
But overall, it would be wise to simply stop spending money on things like this during a time of unemployment or heavy unexpected expenses. That money is better off in your investment portfolio, not your emergency fund.
So how do I go about building an emergency fund?
I get asked this a lot, and the answer is really quite simple. Just start saving. You don't have to have your emergency fund built up in a month. If it takes 6, that's fine. If it takes a year, that's perfectly normal too. The point is that you will need to make saving a priority. There are many ways you can reduce spending which will free up money for savings.
Where should I invest my money?
Once you have funded your emergency fund then you can start focusing on investing for your future. Even if you're itching to invest , it's important to educate yourself on the fundamentals before attempting to trade individual stocks.
There are several options available starting with a company sponsored savings plan, opening a brokerage account, or you can choose an investment manager to manage your portfolio for you. If you have access to a company sponsored savings plan like a 401k, it is a no brainer to invest at least the required minimum to qualify for any company match. A general rule is that you should strive to save at least 10%-15% on your gross income each month.
Choosing the proper asset allocation of stocks, bonds, and cash depends on your risk tolerance and investing time horizon. Someone with 30+ years until retirement and a high risk tolerance may have an asset allocation of 80% equities and 20% bonds whereas someone with 5 years until retirement and less risk tolerance may be better off with an asset allocation of 50% equities and 50% bonds and cash.
Diversification within asset classes provides further protection against risk so within equities, you will want to decide how much you want to allocate to growth vs value and large-cap vs mid & small-cap funds.
Once you have settled on an asset allocation, the most important thing in my opinion is to select low cost mutual funds or ETFs and make your contributions automatic. Fees can have a drastic effect on returns over the long-term.