Chuckles has some good points on inflation, but, given that it sounds like you're just starting out, and plan on using some of the funds for a house in a few years, I might be a little more conservative. Let me stress, inflation is bad, and given our current monetary policy, it's almost inevitable. But, in the end, we'll just be able to offer you a couple of suggestions; ultimately you'll need to choose what will help you achieve your financial goals and (perhaps more importantly), sleep well at night.
Since it sounds like this is going to be a combination emergency fund/house downpayment fund, I'd suggest splitting the funds between your Ally Savings account and a short-term bond fund, such as VFSTX. If you wanted to be slightly more aggressive, you could also fold in a stock component (my suggestion would be Vanguard's Dividend Growth Fund (VDIGX), but I could see an argument for a larger index as well). I'd recommend allocating $10,000-$15,000 in the Ally savings account, and putting the remainder in VFSTX/VDIGX (I'd go as aggressive as splitting the remainder 50/50 between those two).
Here's what I'm thinking when I make those recommendations:
Why keep some money in cash?
In a word, comfort. For me, it's nice to know that I could deal with a $10,000 medical treatment that isn't covered by insurance, or could loose my job on the same day that the stock market tanks, and not be concerned with how I'm going to pay the rent and eat for the next several months. Yes, there is a cost to keep money in cash (inflation). That being said, having some cash on hand may also prevent you from making stupid financial decisions -- either out of nervousness, or out of necessity.
You may not have been investing during the crash of 2008, but people did some crazy things then because they were either a.) too nervous, or b.) had to sell assets at a substantial discount due to liquidity issues. Having some cash on hand -- knowing that you'll be ok for a few months regardless of how bad the world gets -- can calm you in a crisis, and can help you avoid making rash investment decisions. Having cash on hand can also help you avoid the liquidity trap (e.g., having to sell a $10,000 asset for $5,000, just because you need the $5,000 now). This is what Chuckles was talking about when he said "if you're able to tolerate having only half of it available if the market meltdowns when you need it." The problem with this is that market meltdowns and the need to access cash often coincide (e.g., you need cash because you lost your job and you can't find a new one; but the reason you can't find a new job is that the economy is in a recession, and the stock market is also down.)
Living below your means helps cushion you immensely, but having some cash is a great safety net. I would probably keep this limited to $10,000 to $15,000 kept in the Ally savings account. (I'm not aware of another no-fee FDIC-insured account that offers a better rate and allows you ready access to cash, but if you can find one with a better rate, I'd certainly consider it.)
If stocks or other assets get incredibly cheap, you might be tempted to tap into this account to purchase assets. However, by doing so, you will probably lose some level of comfort, and you may expose yourself to the liquidity trap (e.g., you spend all of your cash to make a huge downpayment on the house, but the furnace breaks and the roof starts leaking three months after closing -- you'll probably need to go into debt, or sell other assets to meet those unexpected bills). I know MMM uses a HELOC to address this issue, but to me that's an advanced step that I wouldn't feel comfortable recommending to someone just buying a place.
Also, no less of an investor than Warren Buffet is willing to pay a substantial price in terms of lost earnings/inflation to keep money "in cash": "At Berkshire the need for ample liquidity occupies center stage and will never be slighted, however inadequate rates may be.
Accommodating this need, we primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions. Our working level for liquidity is $20 billion; $10 billion is our absolute minimum" (from his 2011 letter).
Why bonds?
Increased earnings power with stability. Without going into a 20-page dissertation on bonds, their payouts (for a number of reasons) tend to be more stable than the earnings you'd see in a stock index fund (which might average 7% over the last 100 years, but will bounce around much more in the short term time horizon that you're looking at). If you want to be confident that you'll have more money than you started with at the end of three years (and more money than you'd get in the Ally savings account), a short-term bond fund offers that.
Thankfully, bonds (typically) offer payouts that are set beforehand, so their value doesn't decline very much in a down economy. Your primary risk in bonds are that the bondholder defaults (a.k.a., doesn't pay you the money that they promised), and, more importantly, interest rate risk (which is linked to our boogeymonster, inflation). In most respectable bond funds (such as VFSTX), the managers of the fund effectively eliminate the default risk. However, all bond funds are subject to interest rate risk.
What's interest rate risk? (the 30,000-foot view)
Low interest rates (like we currently have) eventually encourage people to borrow money. In our current structure, when people borrow money, we're effectively creating it out of thin air. That means that the entire purchasing capacity of the nation is spread out around more dollars, and each dollar is worth slightly less. To rein in inflation (run-away inflation is really bad--see Germany following WW II, or Zimbabwe), the Federal Reserve increases the interest rate. Unfortunately, this lowers the value of bonds (due to a concept called the time value of money). The bonds that are most impacted are those with the longest length (measured by a concept called "duration"). The upshot of all of this is that a.) we expect the Federal Reserve will have to raise the interest rate in the next few years; b.) you don't want to be an investor in long-term bonds when that happens; c.) short-term bonds (such as VFSTX) should not be impacted as much. (See
https://personal.vanguard.com/us/insights/saving-investing/bond-fund-basics-duration for some more details).
Why choose Vanguard Dividend Growth Fund (VDIGX) over a total stock market index or S&P 500 index?
A dividend-focused fund is a good way to add some equities into the mix (with the goal of getting a higher rate of return than VFSTX, while still maintaining a steady account value). Dividend paying stocks tend to be more stable, mature companies, and there is enormous pressure on companies to maintain their dividend year-over-year. Thanks to the time value of money, these consistent dividends tend to result in stable share prices -- even though these companies are returning dividends to you each quarter.
To see the value of this stability, it may be useful to look at a chart of a fund like Vanguard Dividend Growth Fund (VDIGX) and compare it to the S&P 500, or the Russell 2000 indexes -- just make sure that you include the year 2008 when you draw the chart. You'll see that although all of the these funds/indexes are up over that time period, the VDIGX fund has lower-highs, and higher-lows (that is, it's more stable) than the larger market indexes. And, for most people, that stability is what they want in a rainy day fund, or a fund that they'll be tapping in the next 5 years for a house downpayment.
Again, just to stress -- this is just a different risk/reward profile than what Chuckles put forth -- neither one is right or wrong -- it's mostly about what will make you comfortable. Apologies on some very short explanations on the bond and dividend funds -- I just realized that if I really were to explain everything involved, I'd end up writing a very long ebook, and you'd probably have purchased the house already. Finally, note that all of the above is just written with the short term emergency fund/house fund in mind -- I'd suggest a different course if you were talking about investing in a 401(k) or other retirement account!
