A: When it comes to investing, being “all in” rarely makes sense.
Anyone who’s been in the stock market the last decade understands, all too well, stocks can be extremely unpredictable in the short term. Meanwhile, the short-term obligations of life don’t stop. When was the last time the cell phone company didn’t send you a bill because the stock market wasn’t doing great?
And that’s why one of the secrets to successful investing is keeping some cash out of the market. When you have cash sitting out of the market, that you won’t invest, you can afford to be calm even if the stock market is crashing.
When investors see the value of their entire portfolio falling apart, it’s easy to let panic set in and prompt them to sell, often at distressed prices. Unfortunately, panic selling rarely works out and practically guarantees subpar returns. But if you know that you have cash sitting to the side, which you can use to pay your bills for the immediate future, then you’re less apt to make a poor decision in haste.
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How big should a rainy day fund be? That’s a personal decision based on the level of your financial obligations, income and comfort with financial risk. My suggestion would be to keep at least enough cash out of the market that you need to live on for six months. If you can maintain a year in cash, that’s even better. During the throes of the financial crisis of 2008, it was pretty common for financial advisors to tell their clients to have two years of living expenses out of the market. If you can build that size of a reserve, it’s a great idea.
You’re probably next wondering where to stuff all this cash? One place you probably won’t want to keep it is in your brokerage’s money market or “sweep” fund. These temporary holders for cash typically pay no interest and are really intended to be a place to hold money for a day or so until you buy stocks again.
Instead, you will want to move your rainy day fund into a savings account. Don’t expect much, when it comes to interest rates. Even “high-yield” savings accounts are only paying about 1% a year. But with the rainy day fund, it’s not the interest rate that matters, it’s knowing the cash is safe and accessible that matters.
Matt Krantz is a financial markets reporter at USA TODAY and author of Investing Online for Dummies and Fundamental Analysis for Dummies. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at mkrantz@usatoday.com. Follow Matt on Twitter at: twitter.com/mattkrantz