How much cash should you keep on hand? This is one of the most common questions in the financial planning process. The traditional answer in the financial planning world is:
“Three to Six months of fixed and variable expenses should be kept in cash (or cash equivalents), depending on an individual’s personal situation.” (If a family or individual has two sources of income, then three months is appropriate. If they depend on one income, then six months is appropriate).
It is important to note that this rule has you hold cash in terms of expenses, not income. Therefore, your ’emergency fund’ or ‘cash reserve’, or whatever you want to call it, does not need to be any bigger for a high income earner than for a low income earner.
So, why are we putting a limit on the amount of cash we hold in the first place? Obviously, there are pros and cons to cash, so let’s review them:
- Cash is liquid. You can get it right away (with some cash equivalents within a year at the most).
- Low investment risk. If you invest the money, and need it at a certain time in the future, you risk those investments losing value during that time period. When your money is in the bank, you know you will have the same amount tomorrow, next month, next year, etc.
- Cash makes you feel warm inside.
- Inflation Risk.
- Opportunity Costs.
The problem with cash is that every year it sits in your bank account it loses purchasing power due to inflation. The long term average inflation in the USA has been around 3%-4%. There have been periods of time when interest rates paid on CD’s and maybe even savings accounts kept pace or outpaced inflation. Currently, with interest rates near record lows, this is not the case. So your real return on cash is negative!
Additionally, cash you hold onto cannot be invested into higher returning asset classes. This is called opportunity cost. I.E. you cannot get a 10% return by investing in stocks if you money is sitting in your bank account returning 0.02%. You cannot achieve a relative return of 4.5% by paying the principal down on your mortgage if the money is sitting in your bank account.
So, money is liquid and you can get it fast. However, over time, it is expensive to hold cash because it does not appreciate like other assets. So, how much should you keep??
The general rule of thumb of three to six months of expenses is on the conservative side. You certainly should not hold more than that in cash, and you can most likely get away with holding less. This is especially true if you have more than one source of income or you have significant stock or bond holdings. Three months is a good starting point, and you can asses your levels from there.