There may be times in your life when you realize that you have too much money sitting in cash.
Unless you recently received a large amount, e.g., from the sale of a house or an inheritance, it probably gradually sneaked up on you. It starts with having a few thousand dollars more than you need in your checking account. A year or two later, you find that you’ve gotten comfortable with a far larger amount at your bank or credit union. During periods of stock market volatility, that cash feels safe, and becomes a security blanket of sorts. But in the long run, it can do you more harm than good.
Why not hold cash?
The downside of leaving too much money in cash is opportunity cost. You don’t want to look back 10 years from now and realize that, had you simply invested that extra cash, you would have a lot better return. For example, if you have $100,000 more in the bank than you need (we’ll help quantify that), and you invested it at a 7% return, in five years it would be worth over $140,000. That averages out to about $670 dollars a month, or $22 a day, in missed opportunity, which is enough to pay for your daily coffee, Netflix and gym memberships, and maybe even a car payment.
Although I’m using a 7% rate of return, the past few years have seen the stock market return far greater than that, and we know that some periods in the future will see returns lower than 7%, and some negative returns, as well. But don’t let the short-term uncertainty of returns cause you to keep money in cash that you probably won’t need for five or 10 or more years. In the long run, you are likely to fare far better keeping that money invested. After 30 years, $100,000 invested at 7% could potentially grow to over $432,000.
How much is too much?
There are two primary reasons for keeping cash.
The first is as a safety or emergency reserve, which should have three to six months of living expenses (use the high end if you are concerned about your job security or think you could experience other negative surprises).
The second reason to set aside cash is for major expenditures that you foresee in the next two to three years, such as college tuition, replacing a roof, needing a new car, etc. Adding those two figures together gives you a rough idea of how much cash you should have on hand.
A third reason to keep cash on hand in your bank is peace of mind, meaning that it is literally the only way you can sleep at night. One author referred to this as “patting money”—you don’t actually need it, but you just feel better knowing it’s there, right at your fingertips where you can reach over and (figuratively) “pat” it. This differs from person to person, from zero to quite a bit (senior citizens who lived through the Great Depression tend to want a lot of patting money). But if you have the first two cash reserves covered, your goal should be to keep as little patting money in cash as you can live with.
Another consideration is how much you have in investments that are: (a) not in your 401(k), IRA, or other tax-deferred account; and (b) readily liquid at full or near-full value.
For example, if you have bonds or bond funds that fluctuate very little, you know you could access that money in a matter of days without taking big losses (assuming they’re not junk bonds), so you can view that as part of your emergency reserve (thereby having to keep less cash in the bank). CDs that mature every few months aren’t as good for emergency reserves as cash, but they certainly could be structured to mature in time for those big, known expenditures (roof, car, tuition, etc.).
Stocks and stock funds, on the other hand, are liquid, but might be down in value at the time you happen to need cash. That’s why stocks should definitely not be considered part of your cash reserve. It’s also one of the reasons you should only invest money in the stock market that you won’t need for at least five years.
Where to keep cash reserves
Where you keep your cash reserve depends on the amount. If the total you decide to keep in cash, based on the above, is less than $20,000, just keep it in your bank or credit union checking and/or savings account.
If it is more than $20,000:
• Keep six weeks of living expenses in your bank or credit union checking account (and/or attached savings account);
• Put the rest in a money-market fund that pays higher interest. This could be at your bank or credit union (if they have a money market), your brokerage/investment firm, or an online money-market fund (although the online type may take a day or two to transfer funds. Any of these money market accounts can be linked to your checking account, so you can readily move money between the accounts. This helps you access cash quickly, makes it easy to deposit additional funds, and you should earn a little more interest until you need it. You can compare interest rates for online money market accounts.
• Avoid “too much cash” becoming a problem again in the future. Do this by establishing automated monthly transfers. For example, if you find that your checking account consistently accumulates extra cash each month, whether that is $200 or $2,000 a month, set up automated transfers of that $200 or $2,000 every month from checking to a more productive account. That could be a savings or money market account, but better yet, have it go into an investment account (since, after you follow the above guidelines, your savings and money market accounts will already contain enough cash reserves).
Seek guidance if you’re overwhelmed
Many people end up with too much cash because they’re just too busy to bother with it (in fact, hard work and lack of free time might be the reason you’re financially successful and have too much cash). If that applies to you, you need not miss out on thousands—potentially even tens of thousands—of dollars in earnings from having that money in more productive vehicles. Use automated transfers to keep extra cash going into your investment accounts and consider delegating the responsibility for investing that money to your financial adviser, who can look at your financial situation and apply their professional expertise to keeping your extra cash productively employed and allocated.
Matt Boelter is a financial planner and partner at Viridian.
Viridian provides tax, financial planning, and investment management services. The above is meant as general information, and we encourage you to seek advice from your tax and financial advisers regarding its applicability to reaching your financial goals. Everyone’s situation is unique, and your complete financial picture should be considered before making major financial decisions.
