Investors often overlook the importance of cash in their portfolio. On the one hand, some people error on the side of having too much cash. Due to the effects of inflation, cash actually loses its value over time (its called a loss of purchasing power). On the other hand, some people error on the side of having too little cash in their portfolio. This can be a problem if there is a sudden need for cash (such as in an emergency) and a person needs to sell investments at inopportune times in order to generate the cash needed. Here are three things to consider in to manage cash the right way.
Your Working Capital
The first step to effective cash management is to have enough cash in a checking account so you can cover your regular expenses. You likely have recurring bills that are paid out of your checking account. You also probably pay your credit cards out of your checking account. Your paycheck may be direct deposited into this account. It is a good idea to have one account where all of your financial activity takes place.
You will want to have enough cash in this account so that the balance never goes below the minimums established by the bank. This way you can avoid paying overdraft fees or account minimum fees. You will also want to have enough cash in that account so you don’t have to constantly monitor and/or worry about whether or not there is enough cash to cover the expenses.
On the other hand, you don’t want too much money in this checking account. Since most checking accounts pay little to no interest on funds in the account, you don’t want too much money sitting in there no earning interest.
I have found that having no less than one full month’s worth of expenses and not more than two and a half months of expenses is the sweet spot for most people. I would then recommend setting alerts in your bank account to alert you if the account drifts from these bands. If it consistently drifts high, it may be time to move some of those funds into the next cash bucket: your emergency fund.
Your Emergency Fund
I strongly recommend having three to twelve months of living expenses available for unanticipated expenses. These may include medical expenses, vehicle repairs, and job loss. The size of your emergency fund should correspond to your employment security and anticipated income volatility. Those with stable and predictable income may not need as much of an emergency fund. Someone whose employment is not as secure, such as those who work in industries that are susceptible to economic fluctuations, will likely want a larger reserve of cash on hand.
The three most important factors when determining where to keep your emergency fund, in order of importance, are: liquidity, segregation, earnings. The most important factor to consider when deciding where to keep your emergency fund is that it needs to be accessible/liquid. You need to be able to access these funds within 2-3 business days without any type of withdrawal penalty. The second most important factor is that they need to be segregated from your working capital funds. In other words, they should not be kept in your checking account where they risk being spent. Finally, given the two previous factors, the final consideration is that the funds should be invested the highest earning account that satisfies the two previous conditions. This may be a savings account at your bank. It may be an online savings account. It may be a money market fund. There are several options.
Long-term Wealth Portfolio
The third step of good cash management is to allocation some cash to your long-term, wealth-building investment portfolio, after the previous two steps are satisfied. A long-term portfolio will not want too much allocated to cash because cash has historically had much lower returns than other asset types. Nevertheless, cash does play an important role in that long-term portfolio: liquidity.
Every portfolio needs some level of liquidity. This allows the portfolio to meet withdrawal requirements, rebalancing needs, and the like. In general, about 1-2% of a long-term portfolio might be allocated to cash and cash equivalents.
