Build an Emergency Fund Before Investing: A Crucial First Step

Before you begin to invest, check this key item off your list.

There's a reason we're told to invest our money with a stock broker rather than leave all of it in the bank. Investing is an effective way to grow wealth, and you can earn a much higher return on your money by buying stocks as opposed to leaving your cash in savings and only getting paid interest. But if you're interested in investing, there's one key move you'll need to make first -- build an emergency fund.

What is an emergency fund?

Before you put money toward any goal, whether it's retirement, buying a house, or investing, you should first make sure you have a solid emergency fund. What exactly does that mean?

The general convention is to have enough money in the bank to pay for three to six months of essential bills. That way, if you lose your job, you'll have cash reserves to fall back on. Similarly, if you encounter a large expense out of the blue, you'll have the option to tap your savings and avoid landing in debt.

In some cases, you may want to have more than six months' worth of living costs available in savings. The coronavirus pandemic has taught us to expect the unexpected. One year ago, no one could've imagined our lives would be upended for 13 months and counting. So at this point, saving more like nine to 12 months' worth of living expenses wouldn't be a bad idea. This especially holds true if you're self-employed or are the sole breadwinner in your household and have multiple dependents.

Why emergency savings come first

Now that we've covered what your emergency fund might look like, let's get back to why it's important to establish one before investing. And the reason is this: If you need money in a pinch and tap your savings, you won't risk losing money. Yes, you'll withdraw money from your account, but that's not the same as losing money.

On the other hand, say you don't have an emergency fund, you need money, and the only source at your disposal is your brokerage account. If you take a withdrawal when your investments are down, you'll actually lose money -- which is why you need savings in the bank to fall back on.

Say you have $10,000 in your savings account for emergencies and you need that $10,000 in a pinch. No matter when you go in to access that sum, you'll have $10,000 available to withdraw. Now, let's say you put $10,000 into a brokerage account and that same need for money arises. What happens if your investments have fallen to be worth only $9,000 the day you need that cash? Suddenly, you're locking in a $1,000 loss by removing your $9,000 from your account -- and you're leaving yourself $1,000 short of the sum you need.

Don't rush into investing

To be clear, investing is something you should aim to do over a long period of time, and the sooner you start, the more wealth you'll have a chance to accrue. But you shouldn't put money into a brokerage account until you have a solid emergency fund. Not only should building emergency savings trump all other financial goals, but you need cash at your disposal where your principal (the amount you deposited) is guaranteed. A brokerage account doesn't achieve that purpose, so don't open one until you're all set with your emergency cash reserves. And if you are ready to begin investing, take a look at our beginner's guide to brokerages to get started.