5 Tips for Your Emergency Fund Portfolio

The past several years have brought a negative convergence for emergency-fund investors. On the one hand, the financial crisis underscored the importance of building a cash cushion to cover your costs in case of job loss or big, scary, unanticipated expenses such as medical bills or home repairs. At the same time, available yields on emergency-fund-appropriate investments have shriveled to next to nothing.

Investors might be tempted to skinny down their emergency funds to the bare minimums or to forgo them altogether, relying on other sources of emergency funding, such as 401(k) loans or home-equity lines of credit, as their fallback plans. Alternatively, they might be inclined to venture into higher-returning securities with higher risks to match, such as bond funds, bank-loan funds, or even high-quality dividend-paying stocks.

Even as you will doubtless give your long-term portfolio more of your time, it's still worthwhile to give due attention to your emergency-fund portfolio--both in terms of its size and its contents. Here are some tips for putting yours together.

Tip 1: Shop around for the best safe yield you can find. Even as it might be tempting to venture out on the risk spectrum in search of a better return on your emergency-fund money, that's not a great idea. The yields on good-quality short-term bond funds are no higher than--and in some cases even lower than--what you can earn on a high-yield online savings account today. Add in the fact that bond-fund investors will have to contend with at least a little bit of price volatility and the case for sticking with true cash instruments is even clearer. To pick up an appreciably higher potential return than you can earn on your cash--whether with bond funds, bank-loan investments, or (gulp) stocks--you'd need to be willing to risk that your emergency-fund money might be in a trough at the very time that you need to tap it. This article discusses the pros and cons of various investments for your emergency-fund cash.

Tip 2: Right-size it. In addition to thinking about what will go into your emergency fund, it's also valuable to make sure that you're staking no more or no less in your emergency fund than is necessary. Three to six months' worth of absolutely essential living expenses (mortgage or rent, taxes, utilities, and so forth) is a reasonable starting point when setting your emergency-fund amount. But think of it as just that: a starting point. From there, you'll want to customize your emergency-fund amount based on your own situation. The basic question is this: How much time would you need to replace your job if you lost yours? The key swing factors that should affect your decision are how flexible you are in terms of your career choices and lifestyle.

Consider holding a larger emergency fund (six months' to a year's worth of living expenses--or more) if you:

• Have a high-paying job
• Hold a position in a highly specialized field
• Are self-employed
• Work on a freelance/contract basis
• Have dependents
• Have a non-earning spouse
• Have high fixed expenses, such as a mortgage, auto loans, and tuition bills

On the flip side, you may be able to get by with a smaller emergency fund if you:

• Have a good degree of career flexibility because you are in a lower-paying position and/or haven't yet developed a specialized career path
• Have other sources of income that could help defray a large share of household expenses, such as a spouse with an income
• Have a great degree of lifestyle flexibility (for example, you would be willing to relocate or get a roommate)

Tip 3: Consider building a two-part emergency fund. If you've decided to be conservative and build a large emergency fund--and that's a good strategy for people with higher-paying jobs and high fixed costs--you might consider splitting it into two pieces. For example, you might park three to six months' worth of living expenses in a traditional emergency-fund parking place (or a combination of them): your checking and savings account, a CD, money market account, or money market mutual fund.

To help address the fact that those truly safe investments are yielding next to nothing, you could then put another six or more months' worth of expenses (or more) in a vehicle that would deliver a slightly higher yield in exchange for modest fluctuations in principal value. A short-term bond fund such as

Tip 4: Multitask through a Roth. What if you're trying to build an emergency fund while saving for retirement at the same time? If that's you, you can consider building at least part of your emergency fund in a Roth IRA. This can be a viable option because the Roth, unlike a traditional IRA or 401(k), enables you to withdraw your contributions at any time and for any reason prior to age 59 1/2. Under a best-case scenario, the assets in your Roth would increase until you began withdrawing them in retirement. But if you lost your job, you could withdraw your Roth contributions if you needed the money to cover living expenses.

The key drawback to this approach is that, ideally, you'd hold any assets you have earmarked for your emergency fund in something safe, such as a money market fund or CD. (See above.) But those safe investments have very low long-term return potential, making them inappropriate if your goal is long-term growth for retirement.

Tip 5: Line up additional safety nets. The low-yield environment has prompted some investors to forgo an emergency fund altogether and turn to other sources of emergency cash, such as 401(k) loans or home-equity lines of credit. Those avenues shouldn't replace your emergency fund, but they can serve as next-line reserves in case your emergency fund is depleted and you still have a need for cash.

Roth IRAs, as discussed above, can serve as backup assets. Meanwhile, a 401(k) loan will tend to beat other types of borrowing because you'll pay interest to yourself rather than a bank when you take a 401(k) loan. Thus, tapping these assets is preferable to turning to a bank loan or credit card if you find yourself in a financial bind. (The key downside, of course, is that you're short-shrifting your own retirement savings.)

Obtaining a home-equity line of credit may also make sense for homeowners who have built up substantial equity in their properties. The key to making this strategy work is to use the HELOC only in case of a true financial emergency and after you've exhausted other types of funding.