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I am in my mid 20s, I got a (quite) good job and I am able to put asside, each month, about $800. I just started this savings process and currently I have just $800 but at the end of the year I'll have twice as much.

I want to put my money to work - invest in a mutual fund - but I'm not sure what should I do first because I also want to have some backup money for not so happy days (at least $2000 - in a bank account or maybe even in cash). So my question to you, people with much more financial/life experience, is: should I start investing as soon as I reach the minimum investment ammount for the mutual fund (2.5K) and save in the following months or save $2000 first and postpone the investment for a few months (3 if I add 33/month to the regular 800)?

Here is my reasoning for each of these two scenarios - please correct me if I'm wrong:

  1. Invest now, save in the next 3 months:

    • Pros: (hopefully) the invested money generate some more money
    • Cons: I don't have any savings except that month's paycheck if some unexpected expense appear. Pay fees if need to take money from the fund.
  2. Save now, invest in 3 months:

    • Pros: I have some money available immediately in case of emergency.
    • Cons: Investment delayed 3 months, with a possible smaller return for the current year.
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Because of your specifics, I will answer this but the general advice is the same as the similar questions. –  MrChrister Dec 14 '11 at 6:26
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3 Answers

I would focus entirely on the emergency fund first and get it built up as fast as you can. Once that is in place, you've got a cushion that will keep you from going into debt in an emergency. Depending on your monthly expenses, $2000 seems low for that. I'd aim for 3-6 months worth of expenses. Note that this is $800 less than your monthly income because of your savings.

Once you have your emergency fund in place, then follow a formula like @MrChrister's to invest for retirement and save for future major purchases (car, house, vacation, etc).

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+1 First to think about the rainy day tomorrow, when that's covered - deal with the rainbows and unicorns of successful long-term investments. –  littleadv Dec 14 '11 at 7:39
    
Rainy day first. Because if you invest into anything and need money badly, it may happen that the markets are not favourable, moreso in short term and liquidating the mutual funds may lead to a loss. –  Dheer Dec 14 '11 at 11:08
    
+1 - No harm in this, but I feel that the head start of investments now will be more beneficial than an emergency fund. A twenty something has a lot less risk than a 40 something, and I just feel there are fewer emergencies to address. However it isn't my tolerance for risk the poster needs to consider. –  MrChrister Dec 14 '11 at 14:50
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@MrChrister - Uh, exactly. Risk tolerance is tough to measure. To support your point, there's value in the learning curve of seeing one's $1000 portfolio volatility, then $2000, etc. it's far better than instantly dropping $20K into an S&P fund and seeing weekly $1000 swings. My comment on your response below is the low risk answer. I don't just see your point, I actually agree, but see both sides. –  JoeTaxpayer Dec 14 '11 at 17:25
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Ok. I'll ask - Does the job offer a 401(k)? Matching deposits?

You see, the answers given depend on your risk tolerance. There are two schools of thought, one extreme will tell you not to start investing until you have the emergency fund set up, the other, start from day one. I accept there are pros and cons to either approach.

But - if you have access to a matched 401(k), even a conservative, risk-adverse approach might agree that a 100% match (on the first say 5% of your income) is preferable to saving in a low return emergency fund. If the emergency occurs, a low interest loan for the need is a cheap way out. Since the money goes in pre-tax and is matched, being able to borrow out half (IRS rules) effectively lets you borrow more than you deposited out of pocket. And the word emergency implies a low occurrence event. Deposit to the match and start the emergency fund in another account.

If no matched 401(k) at work, the other two answers are great.

Edit - To clarify, and answer a comment below - say the risk isn't just a money emergency, but job loss. $1000 deposited to the 401(k) cost $850 out of pocket, assuming 15% bracket. After the match, it's $2000. After the job loss, if this is withdrawn, if the 15% still applies (it may be 10% or even 0%) the net is $1700 less the 10% penalty, or $1500 back in your pocket. There are those who will say they are just not comfortable running an emergency account so lean, I understand that. For the OP here, $800/mo is nearly $10,000 per year. If even half of that can be deposited pre-tax and matched, the account will grow very quickly and there would still be cash on the side.

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Oh. Basics. I feel silly forgetting that one. –  MrChrister Dec 14 '11 at 18:36
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+1, giving up employer's 401k matching if its available is giving up free money. Unjustified, almost always. –  littleadv Dec 14 '11 at 18:48
    
@MrChrister - Inherent advantage to 3rd guy in. I read you and the other response, had a beverage and swoop in with a missing tidbit. All in good fun of course. –  JoeTaxpayer Dec 14 '11 at 20:57
    
@littleadv - curious - 'almost.' When would it not be right to grab match? Aside from Guido charging 10% vig per week, lest he break your legs. In which case, the victim is not asking for advice here. The ability to double your money, yet borrow half (i.e. your full deposit) at sub 5% is very compelling. –  JoeTaxpayer Dec 14 '11 at 20:59
    
@Joe, "almost" is because I cannot think ahead of any possible situation, and there might be one where it is justified. I would think that people who don't earn enough money to feed their kids, should first take care of the empty fridge, and only then put some money aside in 401k, as an example. –  littleadv Dec 14 '11 at 21:28
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With $800/month extra? Do both.

(I am ethnocentric enough to assume you live in the same country as me)

First, figure out what your emergency fund should look like. Put this money in a high yield checking or savings account. Add to it monthly until you reach your goal. It should be 3 to 6 months of your total monthly expenses. It will be a lot more than $2k I suspect. You will earn bubkis in interest, but the point of the emergency fund is a highly liquid asset for emergencies so you can choose cheaper car insurance and not buy warranties on stuff.

With your $800/month, split it up this way:

$416/month into a Roth IRA account at Vanguard (or Schwab or Fidelity) in the Star Fund (or similar low cost, diversified fund). The star is $1000 to open, pretty diversified. $416 is a lazy number that comes close to the $5000 annual limit for a Roth IRA in the US. Contribute like clockwork, directly from your paycheck if you can. This will make it easy to do and get you the benefit of dollar cost averaging.

$200 or $300 into your savings account until you reach your emergency fund goal.

$85 - $100. Live a little. Speculate in stocks with your vanguard account. Or rent fancy cars. Or taken a vacation or go party. If you are saving $800/month in your early 20 be proud of yourself, but have a little fun too so you can let off steam. It isn't much but you know you can play with it.

Once you reach your emergency fund, save up for your future house or car or plane tickets to Paris. Ask another question for how to save up for these kinds of goals.

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The Roth is a great idea, but I'd add one point. Without debating the proper size for the emergency fund, I recommend the Roth be kept liquid, money market or CDs. As time passes and the real emergency account starts to get close to the right level, start to move the Roth to long term investments. In other words, no Roth money goes long term until the outside funds plus the Roth cash exceeds the emergency fund goal. In a true emergency, you can withdraw the Roth. This strategy delays the investing aspect but not the funding. You may miss a bit of market return, but staying 'safe.' –  JoeTaxpayer Dec 14 '11 at 14:25
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