Keep Your Money Out of the Mattress: Investing for the Short Term

Joanne Cleaver

The only sure thing about emergencies is that you'll have one.

When? Where? How? And finally, what will it cost you?

Who knows? That's why financial advisors recommend clients have short-term savings ready for the random car accident, unexpected education fees and unplanned medical expenses.

But stow that cash in the wrong place, and you'll be facing a different sort of emergency: losing money you thought was there.

Beyond a few hundred or a thousand dollars in bills, it's not smart to build up a cash hoard at home, says Michael Guillemette, assistant professor of personal financial planning at the University of Missouri at Columbia.

Theft is an obvious risk. But you could also see your emergency fund burn in a house fire. Alternatively, it could blow away in a tornado or disintegrate in a flood. Then you've been hit twice -- once with the actual emergency and again with the loss of cash meant to tide you over.

[Read: Can a Roth IRA Be Your Emergency Fund? ]

Insurance companies typically cover only $200 of cash that customers claim they had at home. "It's easy to claim you had hundreds or any amount. How would you prove it?" Guillemette says.

The other immutable force that will erode your dollars is inflation. Hold onto fistfuls of bills, and they will be worth less and less. Meanwhile, the cost of recovering from an emergency will grow, and you'll soon have a gap: Your fund won't actually cover emergencies.

Leaving cash in your checking account or parking it in a savings account isn't much better than stowing it in a fake can of beans on a pantry shelf, financial advisors say, because inflation gets to it there, too. In the long run, rusty cash can actually cost you as much as pricey credit cards.

The key factor for your other options, such as certificates of deposit, mutual funds and retirement accounts, pivots on how much it will cost to get your money for that new refrigerator.

Penalties and early withdrawal fees will eliminate many mutual funds and investment tools, which are typically engineered for the medium and long term. Your goal is not to actually make money, but to avoid losing money by eroding the amount you have saved in those accounts or accruing credit card interest.>

[See: 7 Ways to Pay Less for Your Investments.]

Financial advisors recommend these other options:

-- Guillemette is a fan of Treasury Inflation-Protected Securities, which change according to the Consumer Price Index. With very short-term redemption times, TIPS are the best inflation hedge for preserving your cash, he says, and they can be purchased for as little as $100 directly from the U.S. Treasury Department.

-- Consider buying laddered CDs in three-, six-, nine- and 12-month maturities. As each certificate matures without being plucked for an emergency, roll it over. Even small gains from the CDs with the longer maturities will help offset inflation for the CD portfolio as a whole.

-- Increase your emergency fund by 50 percent for each primary household wage earner who is self-employed. The ups and downs of entrepreneurship are a notorious strain on cash flow. Don't put your business in competition for cash with your household.

-- Create a separate account for a medium-term goal, such as buying a car with cash or accumulating a down payment on a house, says J'Neanne Theus, CEO of Marathon Financial Inc. in Columbia, Maryland, and an adjunct instructor at Howard Community College. "A separate account helps you see meaningful progress toward that goal and helps you resist hitting up that account for other things or for emergencies," Theus says.

-- You can reap investment income over the two to five years it takes to amass enough money to buy a car or make a down payment on a house, and you won't be discouraged by seeing those finish lines pushed back by emergencies.

-- Theus also recommends examining your health plan to understand the copays for, say, emergency room visits. If your employer offers a health savings account, save money for health care through that payroll deduction plan and insulate your regular emergency fund from medical bills.

-- If you're on a lucky streak and your emergency fund grows untouched, rebalance it by sweeping out the excess into other investments," recommends Chuck Bigbie, a certified financial planner in Tulsa, Oklahoma, who teaches retirement planning at the Tulsa Community College's Continuing Education and Workforce Development program.

Perhaps the most insidious threat to your emergency fund is yourself.

[Read: Are You an Asset in Your Own Portfolio?]

Bigbie says about a third of his clients just can't keep their hands out of the cookie jar. Like other advisors, he recommends clients have three to six months' worth of living expenses in an easily accessed account, but he also observes that most life emergencies inflict out-of-pocket costs of less than $10,000.

That's enough to pay for a new roof ... or a pretty ritzy vacation. Some clients can't resist redefining "emergency" to include retail therapy and other splurges.

If that sounds familiar, build some accountability into your plan by reviewing the status of your emergency fund periodically with someone else, Bigbie says. "It's only there to cover extraordinary expenses, so don't use it up," he says.