Keeping a budget is not enough. Life always hands us surprises and we often end up with expenses we did not plan for. Because of this there should be another aspect of your financial picture. That other aspect is called emergency money. I like to refer to this your 'OH S#!T' fund.
Emergency money is money that you put away not as an investment and not as savings, but for emergencies. And these do happen. It is best to put away about two months worth of income for this purpose. Some experts say it should be three months. The actual amount is debatable. Whatever you decide on make sure it is enough to adequately handle whatever comes up. The original basis for the three-month rule was the fact that most short-term debilitating illnesses require three months for healing and recovery.
How much should you save for emergencies? Calculating the amount needed should be fairly easy. What you want is enough money to pay all of your bills and cover the normal expenses you have budgeted for a typical month. For example, if your net budget and spending income for a month is $3000 then you should put away $9000 for emergency money. This is not money for investments or for retirement. Those two categories should be allocated separately.
Emergency money is used for expenses such as accidents, healthcare expenses not covered by insurance, and death and disability or other instances where you did not have a budget made for a particular expense. Insurance is a separate issue and should be a separate part of your financial plan. If you do have disability insurance then this will serve in some ways to protect you in the event of short-term disability. Thus, you should determine what the benefit would be and then reduce the amount needed for emergency expenses by that number. The bottom line is to make sure that any applicable insurance actually covers all the contingencies without any problems. You can ensure that is the case by checking the policy or talking with your agent or financial advisor.
Where should this type of money be invested? Ideally it should be in a very liquid investment that is very easy to get to and can be accessed quickly. Money market funds are the most popular option. These are short term, liquid investments that most mutual funds and some banks provide for easy access and cash type liquidity. They usually pay a nominal rate of return somewhere just above the average savings account rate of the typical bank. The risk involved in these types of investments is nominal but should not be discounted. The best recommendation is to read the prospectus and verify for yourself that the manager is investing in dependable and safe short-term investments.
Other possible options for emergency money is the savings account, cash or some other asset that can be easily liquidated without taking a loss. Many CD's would qualify under this category and should be looked at as an option. Of course when investing your emergency money you should be seeking to get the maximum return possible without compromising on safety.