Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Emergency fund investing

Dear Dr. Don,
I've heard that it's a good idea to save six months' living expenses in case you lose your job. For me, it would take quite a while (and money that I could be using to pay off my line of credit debt -- which I used to invest in some "open" funds recently) to save those six months' expenses. Instead of saving all that money now, couldn't I cash in some investments if I lost my job?
Anita Advice

Dear Anita,
An emergency fund is usually invested in money market investments so you don't pay a liquidity penalty when you cash in your investment. Taking on additional risk by investing your emergency fund in stocks or bonds should improve your average return on these funds over time, but you have to accept that you may need to sell these investments at a loss to get at your funds in an financial emergency.

For example, let's say at the beginning of this year you had $10,000 invested in an indexed mutual fund based on the Standard & Poor's 500 index. The index has lost approximately 18.5 percent since the beginning of the year, so your investment is now worth only $8,150. You may be able to realize a tax savings by taking the loss, but you still have fewer funds available because you chose this approach.

Using a laddered CD portfolio, or managing risk by investing in longer-term CDs is an alternate method to investing emergency fund monies in longer-term investments. If the yield pickup by investing in a five-year CD outstrips the potential penalty for early withdrawal, you can justify investing your emergency fund in longer-term CDs.

See an earlier column for a discussion on using longer-term CDs to invest emergency funds and read Bankrate's feature to learn more about building a laddered CD portfolio.

If you have enough in investments outside of your retirement accounts to cover three to six months worth of living expenses, then by all means turn your sights on paying down your credit. It's a first step toward living within your means and once those balances are paid off you can start focusing once again on investing for your future.

If you're not to that point, then taking risks in investment accounts without having low credit balances or an emergency fund just doesn't make sense. You're hoping for the market to save you and that's the wrong way to invest.

-- Posted: July 23, 2002