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What is an 'Emergency Fund'

An emergency fund is an account used to set aside funds needed in the event of a personal financial dilemma, such as the loss of a job, a debilitating illness or a major expense. The purpose of the fund is to improve financial security by creating a safety net of funds that can be used to meet emergency expenses as well as reduce the need to draw from high interest debt options, such as [credit cards} or unsecured loans.

BREAKING DOWN 'Emergency Fund'

Most financial planners recommend that an emergency fund contain enough money to cover at least three months of living expenses. Note that financial institutions do not carry accounts labeled as emergency funds. Rather, the onus falls on an individual to set up this type of account and earmark it as capital reserved for personal financial crises.

A married couple who earns $108,000 annually after taxes should set aside a readily accessible minimum of $27,000 to $54,000 to address unexpected financial surprises. The funds should be highly liquid, remaining in checking or savings accounts. These vehicles allow quick access to cash for satisfying household expenses during an emergency situation.

Emergency Funds and Investing

Financial advisers view an investment strategy as a pyramid. A strong base is fundamentally important to support the levels of risk an investor bears as securities with varying levels of volatility layer over the foundation. Before an individual ventures into intermediate- or long-term investment vehicles, the establishment of an emergency fund is recommended as the first step toward creating stability and minimizing risk. Stashing three or even six months’ income in a highly liquid account, such as a money market, should preclude the purchase of any instrument that holds risk to principal or requires lock-in periods during which penalties are assessed for early withdrawal. As more volatile securities sit atop above the base of savings accounts or Treasury bills, overall portfolio volatility is minimized and necessary access to risk-free capital is optimized.

Prudent advice should deter a new investor from immediately placing savings in an investment vehicle, such as a growth mutual fund, before that individual creates sufficient liquid capital on which to rely in the event of income loss. Growth funds, while less volatile than individual stocks, hold risk to principal that is best mitigated by increased time horizons. A $10,000 purchase of shares in a common S&P 500 Index fund on Oct. 14, 2008, would have seen the value tumble 9% the following day, significantly eroding principal and purchasing power needed in the case of a personal financial crisis. Furthermore, managed growth funds often charge an front-end sales load up to 5.75% or a contingent deferred sales charge (CDSC) against redemptions that would have further impacted principal needed in the event of an emergency.

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