It's good to have a cash buffer just in case your car breaks down and needs fixing, or the water heater goes kaput, or maybe a child suddenly has an emergency and you'd like to help. But how much money should you set aside in this buffer? And how do you invest the money?
If you're still working, the normal advice is to have enough money in your buffer to cover six months' worth of spending in case you lose your job. But if you feel very comfortable you won't lose your job, I think you can focus on a dollar amount of $10,000 to $20,000. Self-employed people and sales representatives, however, should be alert to income drops.
If you're retired, you don't need to worry about losing Social Security, and you probably also can feel quite certain about pension payments and most forms of annuity payments. Further, I think it's reasonable to count on interest payments and most of stock dividends.
Then, after this, figure out how much you spend beyond these fairly safe income sources per month and multiply by six.
Once you've figured out how much money you want to set aside in a buffer, it's time to invest the money. Don't think of this as potential growth money; leave stocks alone. Instead, focus on safety of principal using investments like FDIC-insured certificates of deposit, or short-term investments bundled in a money market fund, which typically keeps its principal value while paying interest.
Most often you earn more when you buy a 1-year CD compared to a money market fund, but right now we're in a period where money market funds pay close to the same (in investment jargon, we have a "flat yield curve"). Currently, there are available money market funds paying more than 2 percent, maybe even close to 3 percent which is similar to 1-year CD rates.
So, at this point I think a money market fund will do the job nicely for your buffer. Then, be disciplined and don't invade the buffer for non-emergency purchases.
Jorgen Vik is a certified financial planner and partner with SKV Group LLC.