Takeaway:
- There’s no one-size-fits-all dollar amount of cash you should have on hand.
- There is a 4-step framework with key considerations to help guide you to a comfortable, personal answer.
- In addition to cash, there are other minimally volatile assets to consider for holding liquidity.
Cash earns minimal interest, but it has a place in the portfolio.
Cash earns nothing for investors. With low interest rates (been near 0%) and rising inflation, cash effectively has a negative real interest rate. You are losing money by holding cash! This reason is why investors don’t like holding cash, and many keep it at a minimum.
However, it is vital to have some cash and liquidity.
Cash allows you to be nimble when opportunities and risks arise. It’s what pays the bills. Cash is crucial to everyday living.
The question then becomes – how much cash should you have on hand?
How much cash is sufficient?
This question is one of the most common questions I get.
As with most personal finance questions, the answer to this question depends on your risk tolerance and comfort. Here’s a 4-step framework that can help you think through what’s right for you.
1. Emergency fund
First, the core purpose of a cash reserve is to be prepared for emergencies such as the loss of a job, medical situations, and/or natural disasters. These emergencies can result in significant financial burdens.
Per Indeed, it takes about 5 months to find a new job on average. The length of time to find a job could be longer or shorter, so having enough funds to cover at least 5 months of living expenses is critical.
Medical situations are harder to anticipate because it varies greatly by the underlying cause. However, medical debt is a severe problem in the U.S. Per SingleCare, Americans ages 19-44 spend an average of nearly $5K per year, with the average annual spending increasing exponentially in higher age groups.
It’s ideal to have the emergency fund cover both at a minimum (i.e., 5 months of living expenses and at least $5K for medical costs).
2. Near-term necessities
The next item to think about is near-term cash needs that are non-negotiable. Perhaps you have children going to college, and you want to pay their tuition. It makes sense to have these funds in cash.
3. Unique opportunities
You may have unique investment opportunities at times, and you may want to be able to take advantage of those opportunities. If that’s the case, it’s worth considering having some reserve for this purpose.
4. Personal multiplier
Each of us has a different risk appetite. I’m more risk-averse and typically like to have double what I expect. This cushion gives me peace of mind. It helps me sleep! Therefore, I apply a 2x multiple on the sum of the above points. If you are less risk-averse, a lower multiplier or no multiplier makes sense.
Does it need to be cash?
No, it doesn’t. The objective is to have liquidity that is easily accessible, does not impact the bigger picture financial plan (i.e., reduce critical investment portfolios), and is not volatile.
Therefore, this liquidity can be in cash or assets with minimal volatility and rewards. There are three types of assets to consider.
1. Certificate of deposit
In simple terms, certificates of deposits (or CDs) are savings accounts with higher interest rates but are more restrictive. CDs are products that banks offer and, in exchange for higher interest rates, customers cannot access those funds for a set period. There may or may not be any penalties for withdrawing funds early.
CDs have interest rates from approximately 0.35% to 2.55%, depending on the length of commitment (3 months to 5 years).
2. Government bonds or treasury notes
The U.S. Treasury issues treasury notes. These notes or bonds are backed by the U.S. government, and they have had minimal risk and volatility historically. Many investors consider treasury notes as risk-free.
These notes offer interest rates from 0.6% to 3.25% for short to long-term durations. You can leverage them to earn some interest while having access to those funds should you need them.
3. Fixed annuities
Fixed annuities are insurance contracts (think of them as financial instruments). The customer investors an amount upfront in exchange for a series of regular payments over time while accumulating interest. The effective interest rate ranges from approximately 1.85% to 2.65% today.
Fixed annuities are conservative options because this product is predictable, and the contract spells out precisely what will get paid and when over time. It’s also similar to CDs in that you can access those funds at any time (although there may be penalties in doing so).
Disclaimer: The contents of this website are opinions and are for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.