Between boomers wrapping up careers and entrepreneurs thinking about new ones, many are considering retiring from current roles to follow other pursuits, passions and opportunities. For these folks, a critical question is how much cash to hold. Cash reserves provide a sense of security, a buffer against a challenging investment climate and dry powder for interesting one-off opportunities. How much is enough? Is there such a thing as too much? The answer is often a dynamic moving target. Here are some considerations:
Do you earn income from employment or appointed positions?
When regular checks are coming in, emergency cash reserves of just a few months of expenses are typically sufficient. But when you move from the W2 (employment) world to the 1099 (portfolio) world, then it’s time to up your cash reserves. For someone not earning a steady income, a minimum of six months of expenses in cash on hand is normal and advisable. For conservative investors, even two years of expenses is not unusual.
Note that this calculation is a multiple of your expenses denoted in dollars and not just a simple flat percentage of your net worth. Before you can know this number, you have to generate an accurate picture of your monthly and annual costs.
Know your costs
If you’ve made a habit of tracking your monthly and annual expenses, you are in the minority. Most often we guide families as they run a retroactive analysis to determine the costs of running their life. The results are often enlightening; mental accounting is difficult. Biases often skew estimates up or down significantly. A changing mix of variable and fixed costs make it even more difficult to remember and mentally forecast. Many people spend considerably more than they think.
The analog paper method of calculating expenses is tactile and may be better for remembering your results. Younger generations are probably more comfortable tracking expenses online. Both methods work. We prefer using Quickbooks for personal expense tracking.
Also known as “dry powder.” Cash set aside for unique investment opportunities is another consideration. How big are the checks that you tend to write for private investments? $25,000 is really the minimum for a private investment to be “worth it.” More often these opportunities are $100K to $250K per investment.
If you are inclined to invest in one-off opportunities, we suggest you hold enough cash for two such events, or between $200K and $500K. Private investments have a significantly higher potential to go to zero so this opportunity pot should not exceed 5% to 10% of your total assets. If it’s not an area of interest to you there’s really no need to hold this dry powder.
Not all cash is really cash
Some investments thought of as cash are not so easily converted to spendable dollars. CDs advertised by banks, for instance, often seem like a sweet deal. Who doesn’t like a guaranteed return? I don’t recommend using them because they lock up your cash and remove the value of liquidity discussed above, essentially defeating the purpose.
Savings accounts are more liquid and are becoming attractive again. With regular rate rises, cash yields of 1.6% to 1.8% on your fully liquid and accessible cash balance is normal today.
If you are holding $1M or more in cash there are ways to get full FDIC insurance on the balance without opening 4+ bank accounts. Ask us and we can show you how.
The next rate rise is scheduled for the Fed meeting on Sept 25th. There is an estimated 95% degree of certainty that rates will increase a quarter point, from 2% to 2.25%. This will help your cash balance earn more yield. The increase normally takes a month or two to reach your cash account.
What about inflation?
Inflation erodes the value of cash holdings. And keep in mind that your own inflation rate may be considerably more than the Consumer Price Index figure. CPI is skewed toward food, heating, energy and gas – all relatively small expenses for wealthy families’ Medical expenses, childcare, education, travel and housing are the largest expenses for the wealthy; these areas rarely track CPI very closely.
You lose money when your cash reserve is set aside for something that has a high inflation profile. Rising prices mean you can buy less travel, healthcare, education and so on. Medical and education costs, in particular, have increased dramatically over the past decade and we don’t see any reason they would slow down. If your spending tilts toward areas with higher inflation, you will need to boost your cash holdings to keep up.
So how much cash makes sense?
If you were hoping for a foolproof dollar amount or percentage of assets to be held in cash, we regret that it’s never that easy. It depends on income, spending, comfort with risk, inflation, interest in one-off investments, career and family situations, and more. The “right” number for you could change considerably over time.
The cash discussion is one we welcome with our clients. Cash balances should be based on facts, not guesses, whims or rules of thumb.
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