With interest rates at 0.5%, it's tempting to stash your spare cash in solid, dividend paying shares.
Having money set aside for a rainy day can help you prevent a financial catastrophe. Yet even when you're not getting much return on your emergency fund, you shouldn't take unnecessary risks with that money -- even if the temptation to do so is huge, like it is right now.
Lousy Alternatives
I certainly won't dispute that having your money in cash nowadays is pretty much a no-win situation. Short-term gilts earn less than 0.5% interest. And even if you find a bank that's offering a high interest rate on a savings account, you'll be lucky to get 2% -- which probably won't be enough to keep up with inflation.
So when one financial expert advised putting your emergency cash to work in blue-chip shares, I could definitely see the appeal. With solid companies like Vodafone (LSE: VOD), GlaxoSmithKline (LSE: GSK), and Centrica (LSE: CNA) all yielding 4% or more, you'd get far more income from dividend payouts than you would in interest on cash investments.
Moreover, while that meagre interest would be all you'd ever get from a bank or money-market account, those shares could actually grow -- giving you additional gains.
As attractive as that idea sounds, however, there's one big problem: it undermines the entire purpose of having an emergency cash stash. When you want liquid, dependable funds available at a moment's notice for any purpose under any conditions, only a savings account really gives you the access you need.
When Disaster Strikes
Small personal financial crises come up all the time. A boiler repair or an unanticipated car problem adds an extra few hundred pounds to an already overstretched budget. With relatively minor items like that, you can afford to take some risk with your emergency funds, and using alternatives like taking on credit-card debt for an extremely short period of time won't hurt you too badly.
But it's the major financial problems, such as losing your job or incurring huge medical bills that require the full resources of your emergency fund.
And while there's no absolute correlation between your own personal situation and the overall economy, you're more likely to lose your job when the economy is bad -- and that's often a time when the stock market will be down, making it a terrible time to have to liquidate even blue-chip shares to raise emergency cash.
The Blue-Chip Blues
The other big challenge with using shares for an emergency fund is deciding which companies are actually low-risk blue chips. A few years ago, you might well have thought the financial institutions below belonged on your list of blue-chip dividend paying shares. You might never have thought they'd ever see a big decline. Yet look at what happened:
Could the same thing happen to Vodafone or GlaxoSmithKline in the future? Sure, it seems incredibly unlikely -- but probably no more unlikely than the financial crisis seemed to most people back in 2005 and 2006.
Moreover, even shares that have held up reasonably well during the bear market nevertheless suffered temporary losses along the way. If you had needed your money back then, you would have had to sell shares at exactly the wrong time, making those temporary losses permanent.
Keep It Safe
Especially when you're first starting to invest, the idea of keeping as much as £10,000 stuck in a low-yielding savings account seems positively ridiculous. It's true that 90% of the time, your emergency fund will seem like an overly conservative waste of valuable money that could be put to better use elsewhere.
But during the 10% of the time when you could really use that money, the security and freedom your emergency fund will give you will make it well worth it.
More on the economy and the markets:
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> A version of this article was originally published on Fool.com. It has been updated by Bruce Jackson, who owns shares GlaxoSmithKline.
