Cash is truly a horrible investment. I’m not talking about folding paper; I'm talking about savings accounts, money markets, and short-term CDs. In the same breath that I say cash is trash, I could also say cash is king. Cash is king as it is the single most important financial planning tool.
Cash = A Horrible Investment
Cash = A Critical Financial Planning Tool
When my 4-year-old daughter gets in trouble and tries to explain why she did something naughty, she always says, “The reason is ……”. As children often do, she learned this phrase from me as I write and say this phrase often. So forgive me for once again using this phrase. Cash is trash, and the reason is simple... Inflation.
Inflation is a hidden tax eating away at our purchasing power year over year. We often think of cash or cash equivalent investments as safe from losses, but the truth is that we lose money every year on cash accounts. Inflation is a hot topic currently, but until recently, inflation has been very mild for several decades. Despite mild inflation, as you can see below, the value of the dollar has been cut in half since January of 2000!
This chart shows that $10,000 in the year 2000 would only be able to purchase $5,673 worth of goods or services today!
Here’s the catch 22: although cash is a terrible investment, I can think of no better financial planning tool than liquid, stable, and reliable cash equivalents accounts. There are dozens of reasons why having extra cash can help improve your financial situation and, perhaps more importantly, alleviate stress and anxiety. Just to name a few:
- Job loss
- Unexpected bills (home repair, car replacement, medical bills, etc.)
- Opportunity to buy a business
- Investment opportunities
- IRS audit
- Helping a family member through a difficult time
The challenge, of course, is finding the right balance between holding enough cash for emergencies and opportunities, yet keeping your money working for you. Of course, you want to keep your money working (to combat inflation), but also you don’t want to experience an opportunity loss/cost. An opportunity cost is the cost of missing out on gains by not investing in an opportunity. Let's take, for example, the same period in the graph above. Instead of letting cash sit stagnant, look at the results if it was simply invested in the S&P 500.
As you can see, your $10,000 investment grew to over $39,000. This means the opportunity cost of NOT investing would have been $29,000.
To achieve balance regarding cash as an investment versus a financial planning tool, you should separate the two concepts. You should not consider cash as an investment at all. Cash is an insurance policy for the items listed above. Your investments should be fully invested within reason in an asset allocation that works for your risk tolerance and timeline.
What is the right amount of cash? This is a deeply personal question, and the answer will vary greatly depending on your situation. However, there are some basic rules. My general advice is to keep cash equal to a certain number of months' expenses. The number of months varies depending on your situation:
- Dual income households (3-6 months of expenses in cash)
- Single income households (6-9 months of expenses in cash)
- Retired persons (9-12 months of expenses in cash)
- Business owners (Personal cash should be 12 months of personal expenses.)
Notably, all of this is circumstantial and should be analyzed much more thoroughly in a personal financial plan. A proper plan finds the right balance between having your assets work for you while maintaining sufficient reserves.
Written by: Brice Carter
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