Don’t neglect short-term savings

You probably know that you need to save for retirement by making long-term investments. But too few people focus on another critical need: short-term savings. Ignore short-term savings and you may end up wiped out, perhaps even in bankruptcy.

You need short-term savings to protect you against financial emergencies and to pay for predictable expenses, such as vacations, new cars and weddings. You have two choices:

(1) Save up and earn interest, or

(2) Borrow the money (often via a credit card) and pay interest (at a much higher rate).

This sure seems like a no-brainer to us.

How much money do you need in short-term emergency savings? It depends on your situation. Generally, aim to have at least three to six months of living expenses in an emergency fund. If you’re a software programmer who has little trouble finding work, a couple of months’ worth may be enough. If you’re a performance artist who’s the sole supporter of six children, three aged parents and a llama, you may want to aim for a year’s worth of expenses in ready cash.

Beyond your emergency fund, any funds you’ll need within three to five years should not be at risk in the stock market. That’s right — stocks can be terrific for long investment periods, but in the short run, anything can happen. You don’t want the market to plunge three months before you have to make a massive tuition payment.

Short-term savings belong in instruments such as money market accounts, certificates of deposit (CDs), short- to mid-term government and corporate bonds, and bond mutual funds. Your return will vary, of course, but right now money market accounts are paying around 2 percent. CD rates depend on how long you’re willing to tie up your money, but short-term CDs start out about the same as money market rates and go up in small increments as the term gets longer. Corporate bonds tend to pay more than CDs or Treasury bonds, depending on the risk of the bond.

Learn more about your short-term savings options (and find some great deals) at www.fool.com/savings and www.bankrate.com.

Ask the Fool

Q: What can you tell me about investing in a thoroughbred horse racing stable? I’ve read a lot about it, and it seems as if you need a million bucks to get into it. I’d just like to own one hoof. It’s risky, but no worse than the stock market, I think. My brother says not to invest in anything that needs to be fed. I think it would be exciting to invest in something you can see, pet and cheer for. — A.L. McNeill, via e-mail

A: Hmmm … Well, you probably know much more about the horse business than we do at this point. It may be thrilling, but don’t invest unless you’re confident that you can make money at it. Losing money isn’t too thrilling.

The stock market is indeed risky, but you can reduce those risks by reading widely and learning more about it, and by investing in solid, growing companies for the long haul. Better still, stock market investing can also be exciting, and you can cheer your companies on.

Q: Can I buy fewer than 100 shares of stock in a company? — F.L., Manteo, N.C.

A: Yes indeedy. Through a broker, you can buy as little as one share at a time. Just mind the commissions — if you buy one $50 share of stock and pay a $15 commission, you’re out 30 percent from the get-go. If you’re buying stock directly from a company, such as through a dividend reinvestment plan (a “DRIP”), your money can buy fractions of shares at a time. For example, a $50 contribution would buy you 0.67 shares of a $75 stock. Learn more about DRIPS at www.fool.com/School/DRIPs.htm and www.dripcentral.com and more about picking a good brokerage at www.broker.fool.com.

My dumbest investment

When the stock market was surging, years ago, I vowed to not jump into any of those high-flying Internet stocks. But I watched them every day. The stock “At Home” was trading in the $90s, and then it dropped to $45. I figured if it was at $90 once, it could do it again, and bought 200 shares. I went against my better judgment and it cost me. The company essentially went out of business. — Gerald Boyd, Ramona, Calif.

The Fool Responds: You weren’t alone in getting caught up in the excitement of a stock market bubble. But bubbles burst, as you learned. Just because a stock hits a certain high price, there’s no reason to assume it will reach it again. That high may have been wildly unreasonable at the time. When looking for stocks, seek companies with strong competitive advantages, protective moats (such as when it’s difficult for customers to switch to another company), and undervalued stock prices. It’s dangerous to buy even a healthy, growing firm at the wrong price.