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Is my emergency fund part of my portfolio?

August 3, 2011: 5:05 AM ET

In determining my asset allocation, should I consider bank CDs part of cash or bonds/fixed income? Do I include my emergency fund in my cash allocation or keep it outside of my portfolio? And are REITS seen as stocks or alternatives?
—- Chris C., Richmond, Va.

Before creating an investment portfolio of stocks, bonds, and other assets, you should have an emergency fund, cash set aside in the event of a job loss, serious injury, or any other unforeseen circumstance that could require ready money. This rainy day money is separate from the cash or fixed income portions of your investment portfolio.

The size of your emergency fund should vary according to your circumstances and temperament. If both you and your spouse are securely employed, three-months of normal living expenses may be plenty. Six-months of expenses may be more appropriate if your family's primary breadwinner believes his or her job is not secure. If you want to be extra conservative in these tough times, consider building up an emergency fund of as much as a year's worth of expenses.

Your emergency fund needs to be invested in safe assets you can tap any time, such as CDs, savings accounts, and money-market funds. Don't expect to earn much on this money, especially with interest rates so low today. One way to eke out a little more return is to create tiers—a first tier of cash in checking and savings accounts, and a second tier of short-term CDs, suggests Ameriprise certified financial planner Scott Tiras. "Putting together a CD ladder is not a bad idea for a second tier, with one, three and six-month certificates of deposit," he says.

Once you've fully funded your emergency fund, consider any other short-term CDs you own part of your portfolio's cash allocation; longer term CDs can be classified as fixed income, says Tiras.

As for real estate investment trusts (REITs), which are investment pools that typically own commercial property, count them as an alternative investment, not a stock. REITs can offer high yields from rental income and are typically a bit less volatile than the stock market, helping you to offset market risk. Tiras suggests limiting REITs to no more than 5% of your portfolio.

—Allan Chernoff

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