One area in the investment field that tends to get overlooked involves the establishment of cash reserves. When referring to cash, I am not discussing the money that someone has in their wallet, but rather funds that are in money market or savings accounts.
There are three main categories where it is appropriate to have cash reserves. They are: an emergency fund for unexpected expenses, savings for a major purchase, and part of an investment strategy.
Most people generally realize the importance of having an emergency fund. Unfortunately a significant percentage of people live a paycheck-to-paycheck lifestyle, where they have little in savings, and having an expected expense can cause dire consequences.
Many financial advisors recommend an emergency fund of three months income, sometimes as high as six months. For some people having a specific dollar amount set aside, such as $5,000 to $10,000 might be another approach.
The size of one’s emergency fund has a lot to do with personal circumstances. People run short of money either from a loss of income, or due to unexpected expenses.
For people who have their own business, are in a cyclical industry like construction, or rely on sales commissions, a larger emergency fund is needed. However, individuals with relatively stable employment still need some reserves, as they can get sick or injured, and disability payments will be less than a regular paycheck.
On the expense side the two main expenses would be medical and repair bills. If someone has a high deductible medical plan, more money needs to be set aside versus someone who has complete coverage. Likewise someone who is a homeowner, or is driving an older car would need extra reserves for unexpected expenses.
For people who have high cost debt, such as credit cards a decision has to be made whether to pay off the debt first, or establish the emergency fund. While many financial advisors recommend establishing the emergency fund first, I think a balanced approach is appropriate. Establish a minimal emergency fund, pay off the credit card debt, and then build up the emergency fund to a normal level.
While it is very important to have an emergency fund, someone can go overboard and keep too much money in cash. Some people are diligent savers, and once an appropriate emergency fund has been established additional savings should be invested. This is especially true in the current environment with savings accounts earning essentially zero.
A separate category of cash reserves needs to be established for major purchases that will be undertaken within a year or two. These might include a down payment on a house, a car, or travel. Planned expenditures many years in the future, such as college tuition, do not need to be invested as conservatively.
Money set aside for major purchases does not have to be as liquid as the emergency fund. For example if someone is planning on purchasing a car in 18 months, some of that money could be invested in a bank CD, or a short term bond fund versus all of it being in a savings account.
Cash can also be used as part of an investment strategy. However, it is important that people don’t try to time the market and keep large cash reserves because they are uncomfortable with stocks. Young people should avoid having large cash balances in their 401K plan, given their very long term time horizon. For older people who will be withdrawing funds from a retirement account in the next year or two keeping some investments in cash is appropriate.
Investment returns on cash have been near zero for a number of years. Therefore, cash has not been a very productive investment. Nonetheless, people should refrain from investing funds earmarked for short-term uses in riskier assets, just because of poor returns on cash. In the future short-term interest rates will likely be higher, so cash can certainly become a more viable investment alternative, rather than just a place to keep an emergency fund.