You’re still working – how much cash should you have?
Even successful savers and sophisticated investors are puzzled by this question: How much cash cushion should you maintain, and what portion of your wealth should be invested?
The answer depends on your situation, but most people should carry a modest cash cushion and load up the investment portfolio.
It’s an unfortunate reality that many Americans lack the barest minimum of emergency savings. For folks living paycheck to paycheck, even the slightest hiccup can lead to a debt spiral that loads them up with credit card debt at high interest rates. If you use your car’s gas gauge as an analogy, getting by with little cash cushion is the equivalent of driving around with your needle on empty all the time – it’s a habit that creates unnecessary anxiety.
To avoid a bad-debt scenario, you want a reserve of at least two months of living expenses stashed in cash. Many financial advisors suggest keeping up to six months of expenses in cash, but people tend to build up their cash cushion at the expense of their investment portfolios.
To return to the fuel tank analogy, having six months of expenses in cash is sort of like insisting that your tank is full all the time. You have peace of mind, but it’s not really necessary, nor is the practice especially efficient.
I like to use the 15x rule: Until you have built up an investment portfolio equal to 15 times your current annual income, you should devote your excess cash to investments. So if you make $100,000 a year, shoot for a portfolio of $1.5 million, invested in a boring portfolio of diversified stocks.
That’s because stocks do well over time, while cash, even in a high-yield savings account, pays you almost nothing. When you are in the wealth-building phase of your life, you want to minimize assets in the risk-free rate of return that you receive on your cash.
Fully 80% of people do not have a big enough investment portfolio. Until you build up that nest egg of 15 times your annual income, don’t put more money than your base reserve in cash. Once you’ve got a war chest invested in stocks, then you can load up on cash.
How to manage cash for major purchases
My advice about two months’ reserves refers to your rainy-day fund – that’s the money you need for routine but unexpected expenses that amount to hundreds of dollars or even thousands of dollars, such as car repairs, medical bills or new appliances.
The strategy changes a bit when you’re planning a major outlay, such as a down payment on a house. If you expect to put $100,000 down on a house in four years, you should gradually move that money to cash over four years – so $25,000 a year for four years.
Same thing if you hope to buy a $10,000 wedding ring – move $2,500 from stocks to cash each year for four years.
I know life can move fast, and you don’t always have four years to prepare for a major purchase. So follow this bottom line: Any money you need for a major purchase within the coming year must be in cash.
And this amount is in addition to your general cash reserve of two months.
The idea is that stocks are just too unpredictable in the short term to leave money you know you’re going to need in the market. In periods of extreme volatility, stocks can crash by as much as 50% -- and if your big purchase coincides with a bull market, you won’t have enough money.
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