Over a period of a good many years I have known a great many people who at some time or another have suffered in various ways simply because they did not have ready cash. I have known people who have had to sacrifice some of their holdings in order to have money that was necessary at that time. For a number of years I have made it a point to keep a reserve, should some occasion come up where I need money quickly, without disturbing the money that I have in my business. I hope it never happens to you, but the chances are that some day you will need money, and need it badly...So far, so reasonable. Things arise and people need cash. BUT, lately all and sundry have noticed the extremely low rate of interest paid on deposits. This largely encourages people to either 1) spend their money (which is what the Fed wants) or 2) reach for a higher yield in other places (stocks, bonds, etc.). Since this is a post about emergency funds we'll quickly discourage you from doing 1) and let Grandpa Buffett address 2). Referring to the cash he was bequeathing to his son as an emergency fund, in 1939 he said:
You might feel that this should be invested and bring you an income. Forget it -- the mental satisfaction of having $1000.00 laid away where you can put your hands on it, is worth more than what interest it might bring, especially if you have the investment in something that you could not realize on quickly.
And therein lies the key to the emergency fund. It needs to be liquid. DO NOT be tempted to invest in somewhat risky or longer term opportunities to grab a higher yield. As many found in 2008, higher yield almost always equals higher risk; many funds considered safe did not hold up when the excrement hit the air conditioning. As Ray Devoe put it, "more money has been lost reaching for yield than at the point of a gun." So, only consider bank accounts, CDs, bank money market funds, or reputable** money market mutual funds for your short term funding emergencies.
Now, how much should be placed in the fund? Three months of living expenses should be the absolute minimum. If your job is somewhat tenuous, hold six months worth. Remember to subtract your savings rate when calculating how much you need, as you won't be saving during a crisis. So, say you make $40k (after taxes) per year, while you usually save 15% of your money and want a 3 month fund. $40000 * (1-.15) / 4 = $8500. Now defer consumption, reach your number, park it (even at low interest), and sleep like a baby.
* Each year Buffett hosts thousands in Omaha at the annual shareholders meeting for his firm, Berkshire Hathaway. Despite the fact that it's dubbed the "Woodstock for capitalists," Benji has resisted my entreaties for such a high-minded road trip. Seems to have something to do with the arrival of his new son, who was incidentally named after the founder of Vanguard, Jack Bogle. (Edit: it appears that the naming may have been a coincidence).
** Reputable money market mutual funds are those that largely invest in government debt. Look for words like treasury, federal, govt backed, agency debt, and certificates of deposit. See here for a good candidate.