Key Takeaways
Keeping more than six to twelve months’ worth of living expenses in cash can undermine your financial plan due to low returns and inflation erosion.
For short-term cash, consider alternatives such as money market funds, municipal money markets, or short-term Treasuries.
Staying fully invested is crucial for long-term financial success. Being out of the market for even a few days or weeks can significantly lower your returns.
We’ve been taught all our lives about the merits of saving. However, keeping too much cash on hand can be just as harmful to your financial plan as not having enough. I know that sounds counterintuitive, so let me explain.
Many people find comfort in having plenty of liquid cash in reserve. But we’ve had clients with $300,000, $500,000, or even $1 million sitting in their checking accounts when they first came to see us. Not only is that money earning little or no interest, but inflation is steadily eating away at their wealth. Individuals with large cash reserves have been battening down the hatches while waiting for a recession or other financial crisis to hit, which usually is not the case. By holding onto so much cash they’re missing a huge potential return that can cripple their overall plan (see chart later in this post).
How Much Cash Is Appropriate?
We recommend maintaining three to six months’ living expenses in readily available cash for most clients. This is a reasonable amount to keep in a “rainy day fund,” in case you lose your job, have an emergency medical situation, significant damage to your home, or an urgent family matter. Beyond that, you’re essentially leaving money on the table.
Instead, when assisting clients with temporarily "parking" cash for significant upcoming expenses like a major home renovation, an overseas trip, a new car, or college tuition, the money market route has proven to be the most advantageous. Money market funds are paying over 5% interest and higher over the past year. Meanwhile, triple tax-free municipal money markets are paying in the low 3% range which can be the equivalent of well over 5% depending on your tax bracket. Short-term Treasuries can also be beneficial in this context, as they offer yields of over 5% with minimal risk.
Other Ways To Generate Predictable Cash
Our planning is based on custom portfolios designed to generate sufficient income for your lifetime. This ties into a client’s holistic planning picture as well as personal feelings when it comes to investment risk.
One of the strategies we implement is called “asset location preference.” This strategy places or “locates” assets that are relatively tax-efficient in accounts that are taxed at a higher rate—and conversely, places less tax-efficient assets in tax-advantaged accounts.
If a client comes to us with $1 million in an IRA and $1 million in a taxable account and we want their overall allocation to be 60% stocks, and 40% bonds, that doesn't mean both accounts will hold the same funds or even have the same allocation of stocks to bonds. The tax-deferred IRA account will hold more in bonds, assuming the client is of retirement age and is planning to take money out of their IRA and keep their stock side and taxable accounts focused on growth.
In this example, we would be utilizing the client's tax-deferred IRA to cover their living expenses, since they will need to take withdrawals, regardless, due to Required Minimum Distribution (RMD) guidelines. We can then treat their taxable account with a more growth-oriented mindset, which can be beneficial for their heirs. That’s because the funds would receive a “step-up” in cost basis when the heir inherits. In addition, if we need to access
these funds for their normal living expenses, we can sell certain funds and realize capital gains at the more favorable capital gains tax rate.
Bottom line: You can’t sit on piles of cash waiting for things to happen (or not happen). You need to keep your money always working for you.
Real-World Example
In 2019, we had a client with $1 million in cash who hesitated to invest it for various reasons. At the time he told us: “The market is at an all-time high; it has nowhere to go but down.” And when the pandemic hit a year later, he was right. The market went down sharply, albeit briefly, but he had many new reasons for not wanting to invest. He had some looming personal expenses, although nothing close to $1 million worth. He was also concerned about the potential long-term impacts of the pandemic and the ongoing bear market. But here we are five years later with inflation much higher, so it’s eating up a bigger share of his idle cash. Meanwhile, he’s missed an approximately 86% return in the stock market over that time
(about 13% annualized).
Over the past 20 years, missing the single best week in the market would have reduced your annualized return from 11.2% to 10.6%. (see chart to the left). If you were out of the market for only the best single month, your annualized return would be cut to 10.4% from 11.2%. If you were out of the market for the best year, your annualized return would be cut to 9.2% from 11.2%. The chart below shows the impact of that indecision in real dollar terms on a $1,000 initial investment.
Conclusion
Studies consistently show there’s no replacement for staying fully invested and keeping your money always working for you. If you or someone close to you has concerns about your cash needs or the asset allocation of your financial plan, I’m happy to assist.
BRENDEN LEESE, CFP® is an Associate Wealth Advisor at Novi Wealth Partners
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