Let temperament be guide in saving emergency cash

Q.In your “Planning Tips for the New Year” column (Dec. 29), you said everyone needs cash for emergencies. But if I have credit cards and a personal line of credit, do I still need cash? How much should it be and where should I keep it? – Carl J.

A.Yes, you need a cash reserve to help you manage the financial consequences of a major, unexpected event, like a disability that keeps you from working. Your emergency cash reserve should equal your living expenses for three to six months, depending on your personal situation and temperament. Consider these examples:

•A retired couple with guaranteed income from Social Security and employer pensions and significant investments may choose to keep a three-month reserve. But a retired couple with a conservative temperament may feel that anything less than a six-month reserve is too risky.

•A commissioned salesperson with unpredictable income and few investments may choose to keep a six-month reserve. But a salesperson with an aggressive temperament may feel that anything more than three months has too high an opportunity cost.

Your emergency cash reserve should be held in a safe, liquid investment. Liquid means it can be quickly converted to cash with no penalty or risk to principal. Along those lines, good choices are bank savings and money market deposit accounts, which are insured by the Federal Deposit Insurance Corp., and money market mutual funds, which are not.

Poor choices are certificates of deposit, bonds or bond funds, and common stocks or stock funds, because there is potential risk to principal or penalty associated with their liquidation. Yield is a secondary consideration.

In 30 years of professional practice, I’ve never seen a real emergency that was improved by the use of credit cards or personal lines of credit. For example, if a disability keeps you from working, how will you repay them? That said, credit cards and personal lines of credit can be quite useful when it comes to managing short-term dislocations in your cash flow. Paying the balances promptly will allow you to avoid interest and service charges.

Most people need a cash reserve for major, expected expenses, too. The reason is simple: It’s easier to come up with a lot of money a little at a time, rather than all at once. Generally, your reserve for major expenses should be held in safe, liquid investments. But here’s an exception: If their maturities coincide with your need for the cash, you can buy certificates of deposit, or quality bonds or bond funds, to increase yield.