As the eloquent Janet Yellen once said, “shit happens.” Having a back-up stash of money is essential to weather unpredictable life events. Add up your expenses, and figure out the minimum you spend each month to get by — this should include housing costs, food, education, loan payments, etc. If you have family nearby who is willing and capable of supplying housing or financial assistance, you can probably make do with a 3 month cash reserve. If you don’t, you should aim for 6 months.
Where should this money go though? Most people by default leave it in their checking account. However, the combination of low interest rates on these accounts and inflation means that your buying power decreases over time. You are guaranteed to lose money this way. Only keep enough money in your checking account to pay your bills. So, should you invest this emergency fund in stocks? Nope. The value of stocks is not nearly stable enough for an emergency fund. What about bank CD’s? Nope. You need to be able to withdraw the funds anytime without penalty. Instead, you need to find an investment that roughly keeps pace with inflation, is available anytime for withdrawal, but doesn’t suffer from massive swings in value.
Money-market funds. You are looking for money-market funds.
Money-market funds are mutual funds that invest in mostly in short-term debt. There are quite a few to choose from, and any brokerage account will have a variety of options. As always, I look for funds that have low fees. That’s why I opened a personal Vanguard account and invested my emergency fund in Vanguard Prime Money Market Fund. The fees are low (0.16%), and I can withdraw the money quickly. I still have to pay both federal and state taxes with that fund. If you are in a higher tax bracket and are interested in tax-exempt funds, see if your account offers a state-specific municipal money market fund, like this one from California. You need to be living in the state in order for your dividends to take advantage of the federal and state tax-exemptions.