It is important to invest your money with the goal of increasing your savings for retirement. On the other hand, having a portion of your money easily accessible is important in case you have an unexpected expense. What is the balance between how much you should invest and how much you should leave uninvested?
Even with all of the planning in the world, no one can predict the future. You can’t predict the events in life that are very unlikely - your roof caves in, you receive an enormous uncovered medical bill, or, as we are experiencing now, a significant portion of the population loses their job because of a virus. This year, an emergency fund became essential for employees whose hours got cut, small salon owners who couldn’t work for months, and individuals that were left without a job at all because of the economic impact of the COVID-19 pandemic.
An emergency fund is a lump sum of cash that can be accessed easily. There are general rules of thumb for how much cash to keep on hand. Some people say to keep 3-6 months of your expenses in cash. Others recommend less or more depending on your individual situation. Some people don’t understand why they need so much cash, and others like to have more cash than they need.
Why is it so important to have cash? Wouldn’t it be better to keep all of my money invested?
Any money not invested is not exposed to asset classes like the equity market that have the potential to provide attractive returns over long time horizons based on history (though past performance is not a guarantee of future performance, there are no guarantees with investing, and any investment is subject to a loss that could be as high as the entire initial investment). But, these higher expected returns over long periods of time come at the expense of higher risk, especially over any given short period of time. Money that is not invested in the market is not exposed to the risk of the market. Historically, the US Equity market has had considerable drawdowns. These have been as high as the approximately 80% drawdown seen during the Great Depression. What if you had all of your cash invested during those major market declines and then at the exact same time you lose your job and have an emergency where you need a considerable amount of funds? You could then be forced to take money out of the market when it is significantly reduced. If you instead have that money in cash, you can leave your long-term investments untouched during periods of volatility.
Why not leave all or most of my money in cash? Isn’t that the safest option?
Investing is a balancing act between risk and return. Having lower expected risk by leaving your funds easily accessible in cash comes with lower expected returns. If your money has to work harder than the expected low return in order to meet your financial planning goals, then you could run the risk of running out of money without investing.
How do I determine exactly how much to leave in my bank accounts?
Once you agree that you need to have some of your money liquid but enough of it invested, the question becomes how much should you leave in cash. At Autumn Financial Advisors, LLC, we calculate your emergency cash fund amount based on your personal situation. If you only have one source of income in your family, we like to see your emergency fund higher than families with multiple sources of income. Several other factors such as how old your home is, how many children you have, and your medical history could impact how large your emergency fund should be. Depending on your risk tolerance, we might encourage you to keep a higher cash reserve so that you are comfortable with the remainder of your money being invested for your longer term financial planning goals.
Contact us if you would like help determining the amount you should save in cash. As part of a comprehensive financial plan, we will calculate your personalized emergency fund based on your financial situation.
