By Michael Hathaway, CFP®, CFA®, AIF®
Idle cash might sound like a neutral term but having idle cash on hand could mean you are missing out on opportunities with those funds, especially during times of inflation. When you have more cash sitting in your bank accounts than you need, that idle cash is losing its “purchasing power” since the rate of inflation is outpacing the interest rates paid on balances in bank checking and savings accounts. Given that inflation is at 40-year highs, while the average savings account earns less than 1%, that means your excess cash is dragging down your overall wealth-building efforts. I want to show how idle cash accumulates over time, how much cash you really need, and what you can do to put extra cash to better use.
Origins of Idle Cash
Idle cash can build up in a variety of ways. Young professionals earning more money than they’re used to can find cash piling up in their savings accounts because they don’t know how to put it to work for themselves. More experienced investors may not even realize they have idle cash sitting around in their investment accounts, coming from dividend payouts and fund distributions that aren’t automatically reinvested. Cash from passive revenue streams, such as rental properties, may not be integrated into your investment portfolio and could be left sitting in bank accounts, dragging down your overall investment returns.
Here’s How Much You Really Need
Regardless of where the cash is coming from, having too much of it idle in your portfolio is not a wise financial strategy. But how do you determine the right amount? While there are no one-size-fits-all answers, I believe a few guidelines can help.
A general rule of thumb in personal finance circles has been to hold 3 to 6 months of living expenses as an emergency fund in a safe, liquid, and accessible savings account that has no fees or penalties for accessing the funds. I think that’s a good start, but recent events such as Covid-19, the economic shutdown in response to the virus, and the recent spike in inflation have led me to conclude that a better rule-of-thumb target amount of cash for most working-age adults is between 6 and 12 months. There are other factors to consider when deciding whether you should be closer to 6 months or 12 months. Among these factors that could move you closer to one end or the other are your family situation, as well as the stability of your job and other sources of income.
For instance, if you are single with no one to share expenses with and you work in a commission-only sales job where some colleagues have recently been laid off, you might want to keep your emergency fund closer to 12 months. But if you are married with no kids, and you both work stable jobs where turnover is low, it might make sense to keep closer to 6 months. The key function of this “cash buffer” or “rainy day fund” is to buy time in the case of an adverse event, like a sudden job loss or reduction in take-home pay, allowing you to pay your regular bills while working on a “solution”.
If you simply feel more comfortable with your finances and sleep better at night if you have a 12-month emergency fund instead of a 6-month emergency fund, listen to that voice.
Once that exercise is complete and you have a good idea of how many months of living expenses you need to cover, the next step is to ensure that your savings account is earning a competitive rate of interest. Some potential options are a high-yield online savings account, money market funds, or shorter-term CDs at your bank. While none of these options will be able to match the high levels of inflation we are currently experiencing, they will all offer yields that are higher than the average interest rate paid on balances in a bank savings account.
Maximizing Your Extra Idle Cash
Once you have a fully funded savings account that covers regular liquidity needs (like paying bills over a paycheck cycle or two) and an emergency fund that covers between 6 and 12 months of living expenses, then it’s time to put any remaining cash to work for you.
My recommendation is to create an intentional and well-designed investment portfolio, with five main components: 1) Create an asset allocation tailored to your risk tolerance, 2) Be broadly diversified, 3) Keep your investment fees low, 4) Refrain from emotional investment mistakes, and 5) Be aware of how your investments interact with your income tax situation.
If you do those things, you can benefit from the returns available by investing in the global stock markets, which historically have been much higher than a savings account. For example, since 1971, the S&P 500 (a leading index that tracks the stocks of 500 large public companies in the U.S.), has earned an annualized return of 7.58%—or 10.51% with dividends reinvested.
An important caveat is that unlike a savings account, investments in more volatile assets like stocks do not have guaranteed returns, and we simply have no idea what returns they will earn in the future. However, the lack of a guaranteed return is a significant reason why a diversified portfolio that includes riskier assets like stocks can earn much higher returns over time than a bank savings account and can help you build greater wealth over a longer time horizon.
How We Can Help
If you think you might have too much cash, we’d love to help. We can help you think through the right amount of cash you’ll need to keep for a rainy day, and then develop an investment portfolio that can help you build wealth over the long term to help you achieve your financial goals.
To get started, email me at Mike@wealthmatters.com or call (707) 428-5500. I would love to hear from you.
Michael Hathaway is a fiduciary financial advisor at Epsilon Financial Group, Inc., an independent, fee-only wealth management firm. Mike has worked in the finance industry for more than 20 years and brings a wealth of knowledge and experience in sophisticated financial planning to help his clients make sound financial decisions. He is known for caring deeply for his clients’ well-being, being compassionate, and thinking creatively to help clients attain their financial goals. He prioritizes building long-term relationships and takes the time to listen, understand, and explain so that his clients feel confident in their financial plan. Mike is a CERTIFIED FINANCIAL PLANNERTM, Chartered Financial Analyst® (CFA®), and Accredited Investment Fiduciary® (AIF®) professional; he has a bachelor’s degree in cybernetics from UCLA and an MBA in finance and accounting from the University of Virginia. When he’s not working at Epsilon, you can find Mike enjoying anything related to exercise and fitness. He especially loves activities in the great outdoors, such as mountain biking, camping, hiking, and snowshoeing. In the fall of 2016, Mike successfully climbed to the top of Mount Whitney in a single day, the highest peak in the continental United States. To learn more about Mike, connect with him on LinkedIn.