Should You Build Your Emergency Fund or Invest in the Stock Market?
Creating a financial plan involves a blend of evaluating your tolerance for risk, gauging your relevant time horizon, and developing personal goals. If we've learned anything over the past several months, it's that having cash available is not only preferred, but also an absolute necessity.
At the same time, we're all faced with the challenge of saving for retirement -- the longer you wait to begin investing, the more you'll need to save down the line to reach levels high enough to retire. With these competing priorities at hand, it's valuable to think about the different considerations for building an emergency fund versus beginning to invest.
You need cash
The global pandemic has cast a blindingly strong light on the need for cash. Put another way, you need to have at least some money at the ready in case of an emergency. The term "emergency" here refers to any potential risk within your financial life that can be unknown in timing and amount.
The reasons are clear and simple. First, you don't need to have cash on hand until suddenly, you do -- you lose a job, you incur unexpected medical expenses, or you need to voluntarily leave the workforce to care for an ill family member. While these events may feel improbable before they occur, they most certainly can and do happen. This illustrates why it's simply non-negotiable to have some cash on hand for unexpected expenses.
Next, the current health crisis has also illuminated the staggeringly large number of people who are without work and have run through their savings. These cases are difficult to navigate (to say the least), which is why it's important that you work toward building an emergency fund with at least six months' worth of non-discretionary expenses. If six months' worth isn't possible, aim for three months' worth. Even a modest cash cushion will, at the very least, buy some time for you to regain your footing.
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You also need investments
The beauty of compound interest in your retirement accounts cannot be understated. The sooner you make investing a priority, the more likely it is that you'll be able to cover future costs in retirement -- regardless of whether it's a Roth IRA, 401(k), or 403(b). Consistent, early, and tax-advantaged contributions are the best way to ensure you take advantage of compound interest.
On the other hand, if you only invest and keep no cash on hand, you risk needing to sell shares at a loss to cover current cash deficits. For example, say you have saved $1,000 and decide to invest the entire amount. If the market declines 30% or 40%, as it did this past March, you might be left with only $600. Should you, at the same time, incur an unexpected expense that your regular income can't cover, you might need to sell your investment at a loss.
Striking a balance
The truth is that both cash and investments are very important to the success of any financial plan. However, the reality is that this is simply not possible for many working families in pandemic times. Although the answer is dependent on the facts of your personal situation, a cash cushion will provide more immediate benefit to most people. It's still advantageous to contribute even small amounts to retirement accounts -- even $50 a month -- to ensure that money is continuously working for you.
If there's a way for you to balance holding a reasonable amount of cash (again, three to six months of non-discretionary living expenses) without turning off your retirement contributions, this is advisable. However, this might not be possible. Saving for retirement may have to take a short-term hiatus if your personal circumstances require one, and there's absolutely nothing wrong with that. Still, if you've planned for unforeseen circumstances by having a fully or partially funded emergency fund at the ready, the probability of you needing to turn off your retirement contributions will be significantly smaller.
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