Keep This Much Cash in Savings and Not a Penny More

Peter Lazaroff, CFA, CFP® Chief Investment Officer

People say that cash is king, but they don’t always give their cash the royal treatment it deserves. Cash is great to have for everyday purchases, short-term goals, and unexpected expenses.

But after that, having too big a cash balance in your primary banking account can work against your long term-goals. Since cash loses purchasing power over time, efficient use of cash is a crucial piece of your financial plan.

To make the best use of your hard-earned cash, split it up in three ways: set aside a cash buffer for short-term needs, build up an emergency fund for unexpected expenses, and invest in a diversified portfolio for long-term goals. Here’s how:

Cash Buffer

There needs to be some cushion in your checking account to protect against overdrafts or surprises that result from a mismatch in the timing of automatic bill payments and your paycheck. The cushion doesn’t need to be very big.

Most people find 25% to 50% of one month’s expenses to be sufficient. If you have highly unpredictable income and expenses, then a full month of expenses is better. This is common among people that put reimbursable business expenses on their personal credit cards.

Your cash buffer belongs in your primary checking account. It acts as a level to mentally associate with a balance of zero. For example, if your cash buffer is $5,000 and you dip below that amount, you might consider exercising additional care with your expenses and payments.

Emergency Fund

I’m a big believer in having six to 12 months of expenses on hand for life’s unexpected surprises such as medical bills, car repairs, job loss, and so on. Within that range, the specific size of your emergency fund should correspond with your level of job security and the potential volatility of your income.

The best place to keep an emergency fund is an online savings account, separate from your primary bank. These banks pay higher interest rates than the traditional brick-and-mortar banks.

An added benefit of using an online bank that is separate from your primary checking bank is that it will make it easier to resists the urge to dip into those funds for non-emergency purposes.

Read More: How to Set Up Your Emergency Fund

Invest Cash for Long Term Goals

Saving for long-term goals like retirement requires you to grow your savings faster than inflation without taking undue risks. Holding too much money in cash can make this process difficult for two reasons.

The first reason is that cash has provided poor long-term returns. Due to taxes and inflation, cash you save today will buy you less in a few years. But cash invested in stocks and bonds has a track record of growth over the long-term. That’s why for long-term goals we recommend moving cash into a diversified portfolio.

The second problem is the psychological mind games that come into play. When stocks are going up, people tell themselves that they will wait for a pullback to deploy excess cash; and when stocks fall, there is an urge to wait for them to fall further.

To win these mind games, set up automatic deposits from your bank to your investment account. BrightPlan Investment Accounts make this easy. Any deposits you make to a goal are automatically invested in a diversified portfolio.

In an ideal world, we could meet all our life goals by simply being good savers and use safe, liquid assets such as cash. However, investors need to take risk to generate real returns. Markets will fall from time to time – sometimes more than others – but investors with a long horizon have time to ride out short-term volatility.