One of the few personal finance tips that garners near-universal praise is the idea of having some cash reserves.
For many topics in personal finance, there are seemingly as many critics as there are advocates. You commonly hear phrases such as:
- “The stock market is too risky,” or
- “You can’t retire early because you need health insurance,” or
- “You shouldn’t travel because it’s wastefully expensive.”
I don’t agree with any of these perspectives, but you hear people offer them as feedback nonetheless.
Thankfully, few people disparage having cash reserves because they should be an essential component of everyone’s personal finances. Most of the time.
What Are Cash Reserves?
Cash reserves, also called a “rainy day fund” or “emergency fund,” is money that you have access to in case of an unplanned need.
Typically, these funds are in the form of cash or cash equivalents. We’ll jump into account and investment options later.
Cash Reserves Are Your First Line Of Defense Against Financial Ailments
I’m no scientist, but I recently learned about an immune system concept that illustrates the power of cash reserves.
Lymphocytes are a type of white blood cell, and they either become T cells or B cells with different roles in your immune system. One type fights infections and the other type remembers past infections and goes into action if you are re-infected.
Much like the lymphocytes, cash reserves are a resource that enables flexibility. It can spring into action when a need arises. And it can “specialize” to become whatever type of resource you need in the moment.
Here Are The 3 Main Reasons You Need Cash Reserves
Life can be expensive at times. Unexpected expenses are truly… not unexpected. Events like a car repair, small medical bill, or broken cell phone are likely to happen occasionally.
Recently, a popular stat has inspired many articles and tweets — 40% of Americans can’t cover a $400 emergency expense.
Avoiding Unnecessary Debt
If you don’t have cash available to pay for an expense like this, or if you suffer a job loss, the alternatives don’t offer a positive outlook.
Credit cards often have interest rates over 20% APR, and payday loans are even worse.
A home equity line of credit (HELOC) can be lower interest, but any form of debt can compound if left unpaid.
Help Manage Investment Or Economic Volatility
Even if you have some investments, there’s volatility that cannot be predicted with certainty. This is an issue for retirees especially, since they want to avoid being forced to sell an investment after a large drop in market value.
Most often, people are referring to stocks when they use the term “volatility,” but the concept applies more broadly. If you own rental property or a business, those investments can be affected by market volatility too.
How large of a cash reserve should you maintain if you depend on investments for your livelihood? We’ll dive deeper into this below.
Safeguard Against A Job Change
Job changes are inevitable and even common. Last year, the Bureau of Labor Statistics reported that median tenure for men was 4.3 years and 4.0 years for women. Shifting to a new role every four years is a lot of change.
Of course, unwanted and unexpected job loss can be more of a challenge financially. But, even if you’re choosing to change jobs on your own volition, it’s best to be prepared for the transition.
Perhaps most importantly, having an emergency fund in place can give you the security to boldly pursue a new opportunity in your career or the confidence to leave an unhealthy workplace.
The Downside Of Cash Reserves — Opportunity Cost
Other than a lack of disposable income or self-control, I think the main reason people don’t make maintaining cash reserves a priority is that it’s not exciting. And, frankly, they’re right.
There’s no chance that your cash reserves will suddenly double in value over 10 years, like index funds can.
There’s an opportunity cost involved because the money in your emergency fund is not necessarily being used for something else. But that’s okay. That’s the whole point.
I don’t recommend comparing your cash reserves to your investments because I don’t think of emergency funds as investments.
Instead, I recommend thinking of it as insurance. Insurance costs you money, but it protects you and it makes your life less risky. Your cash reserves has the same function.
If you’re a more aggressive or risky individual, you might disagree here.
How Much Do You Need To Set Aside In Cash Reserves?
Well… It depends! Your cash reserves should be a reflection of your lifestyle’s ability to tolerate and respond to risk.
Consider a few examples.
Single Income Or Variable Income, Larger Cash Reserves
Let’s say you are a single income family including two spouses and three kids. Your job that has to support the whole family is completely commission-based because you are a real estate agent.
This is a situation where you might want to maintain a larger pile of cash reserves. Like 6 months of expenses (or even more!).
You have a lot of people and expenses to attend to. A change in the local real estate market could drastically affect all of your income.
Dual Income Or Consistent Income, Leaner Cash Reserves
Alternatively, if you and your spouse have no kids and both have full-time, salaried jobs in unrelated industries, you may feel comfortable with a more lean, 3-month emergency fund.
It’s unlikely that you would both lose your jobs at the same time, so you would probably still have half of your family’s income available if one of you do have a job change.
Plus, if you don’t have kids or generally have low expenses, it would be easier to “tighten the belt” and adjust your expenses down during the job transition if necessary.
You may have noticed, in the previous example I mentioned that it matters what industry you are and your spouse work in. If you work in the same industry or related industries, this increases your risk a bit.
An external factor could affect both of your employment statuses simultaneously.
For example, if you and your spouse both teach at a public middle school, a cut in the local education budget could impact both of your jobs.
So, this is worth considering.
Choose An Option That Fits Your Family’s Needs
All of the variables above are important to consider. Though, ultimately you need to choose a savings target that is a good fit for your family. It comes down to preference and comfort.
Clearly, someone earning a ton of passive income from real estate might not need as large of an emergency fund as someone who’s primary source of income is an hourly part-time job.
My wife and I both work full-time in unrelated industries and we have no kids, but we maintain an emergency fund of a bit more than 6 months of expenses. That’s just what it takes for us to sleep well at night.
Cash Reserves During Retirement
When you retire, you will likely need extra cash reserves in addition to your standard emergency fund if you are planning to live off of your investments. The rationale here is that your investments themselves are volatile.
You want to avoid needing to sell too many shares to cover your expenses if the market takes an extreme dip. Having cash reserves available can allow you to live off of the cash instead of needing to sell investments right after a crash.
Traditional retirement, mini retirement, and semi-retirement will all require different approaches for your cash reserves.
There can be wide variation in the details of people’s retirement planning, so consider this advice but consult a financial advisor on what approach will be best for your specific situation.
Typically, retirees live off of a combination of investment income, Social Security benefits, and pensions (which are increasingly less common now than in decades before).
Traditional retirees will want to have large cash reserves available, so that they do not have to draw down on their investment portfolios if there is a major market volatility event.
This may sound contradictory to the previous sentence, but I am not an advocate of market timing.
I do think it is wise, though, to understand that volatility should be expected, and you can minimize realizing investment losses if you have cash available to draw from in case of emergency.
Deciding exactly what amount of cash reserves you need should essentially depend on two factors:
- The proportion of your expenses that your investments need to cover.
- Your family’s ability to adjust your lifestyle to minimize expenses if needed.
Here’s an example: Your investments only need to cover 10% of your retirement expenses because you have a great pension benefit. You have budgeted to travel a lot during your retirement years, but if there is a downturn in the stock market, you can travel less or travel to less-expensive destinations in the short-term to reduce your expenses significantly.
In this scenario, you do not need a large amount of additional cash reserves.
Take a look at rolling returns of the stock market over different time periods. For the S&P 500 index, the worst 1-year rolling return was -43%. That would be an unpleasant time to need to make a withdrawal.
Using this S&P 500 historical return calculator, the S&P 500’s worst rolling return over a 3 year period was -35.2% (or, -11.7% per year).
I recommend that retirees keep 3 years of expenses as cash reserves, or more, if they rely heavily on their investments and do not have a flexible expenditure level.
Retirees should work with a financial advisor or tax professional to determine the most efficient way to maintain this cash reserve.
A mini retirement is quitting your job for a period of time with the intention of returning to full-time work later.
Unless you have some kind of passive or part-time income you can count on to cover your expenses during this time period, I would recommend having all of your mini retirement expenses saved up in cash before you pull the trigger.
Plus you should still maintain your normal emergency fund — emergencies are still possible during your mini retirement.
You also want to be prepared in case it takes longer to find new full-time employment than you are expecting.
Cash Reserves During Semi-retirement
Semi-retirement is what I cover on my home site, Semi-Retire Plan. I have talked through the details of semi-retirement and how you can access your retirement accounts early if you want to semi-retire before you reach 59½.
The abridged description of semi-retirement is that you can work part-time for a period to bridge your full-time working years to your full-retirement years.
This can give you a lot of flexibility and help you retire sooner.
For semi-retirement, you will still need your standard cash reserves plus some extra, depending on how dependent you are on your investments.
The exact amount of cash reserves that you need, though, can vary based on your family’s ability to adjust your expenses in the event of market volatility.
As you approach full retirement, you should consider increasing your cash reserves as you become more dependent on your investment income.
Where Should You Keep Your Cash Reserves?
For most people, especially while working and maintaining cash reserves to cover only a few months of expenses, I recommend keeping the money in a high-interest savings account.
Even after recent interest rate decreases, banks like Ally and Barclays are offering over 2% interest on savings accounts.
You won’t become wealthy on 2% interest, but it’s better than earning nearly zero percent if the money was sitting in a checking account.
And, remember, your cash reserves are insurance, not an investment. The best thing about using a savings account is that the money is extremely easy to access if you do have an emergency.
If you’re looking for a slightly higher return on your money and you have a larger amount of cash reserves, you could consider laddered certificates of deposit (CDs).
With this strategy, you buy CDs of varying terms, then when the shorter-term CDs come to term you can use the money if you need to. If you don’t need it, you can re-invest it in a new CD, and repeat the process.
For most people, this approach is unnecessarily complicated and a savings account will offer a return that is nearly as high.
You should not keep your cash reserves in something that is volatile. Remember, this money needs to be readily available if you need it unexpectedly.
With your new cash reserves plan in place, you are now prepared to deal with the small problems life will throw at you. You can sleep well knowing you won’t be going into debt tomorrow!