Five Reasons to Have Some Cash Equivalents

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5 Reasons to Have Some Cash Equivalents

We have a large sum of money just sitting in our bank account and continue to save more. I’ve been afraid to put this money back into investments, but I also feel like it isn’t doing any good sitting at the bank earning less than one percent interest. Should we invest this money? I’ve heard that you should have some cash reserves, but how much cash is too much?

Managing your family’s cash is key to meeting your financial goals. There are at least five reasons to hold cash. Without a good reason to hold cash, you may be holding too much. Here are the guidelines to help you evaluate your situation.

1. You need cash for daily expenses.

It is difficult to run a family budget if your bank account has the bare minimum. We recommend keeping your checking account with between two and three times your monthly expenses. If you are paid once a month, your bank account should have enough to cover two months of expenses the day before you are paid, and three months the day after. This gives you a generous cushion for checking and also provides for unexpected repairs or big purchases. Whenever your checking account goes over 3 months of take-home pay you should consider moving some of it into a higher paying investment.

2. You need an emergency fund in case you are unemployed.

The first three months of your emergency fund are in your checking account. An additional three months should be invested in vehicles that could be easily sold within 90 days, not kept in cash. Your emergency fund investments should not be in a retirement account but rather a standard brokerage account.

The investments should be easy to sell should the need arise. We recommend using no-load, no-transaction fee mutual funds or exchange traded funds for this reason.

In the event that your emergency fund is small, you should choose an investment stable enough to guarantee three months worth of expenses. If your emergency fund is large enough however, you can diversify across stability and appreciation, using investments that fluctuate more but pay a higher rate of return.

3. You may be saving for a specific financial goal.

Assets that are set aside for specific goals within a two-year horizon should be put in a stable investment choice. Fixed or variable rate CDs may provide the best combination of security and stability for this purpose. You can also purchase shares in mutual funds or exchange traded funds that invest in the foreign or domestic bond markets.

The longer the time horizon of what you are saving for, the more you can consider taking additional risk for a chance at higher returns. For goals over seven years away, we recommend taking your chance with stock investments.

4. You need to have some stability in your portfolio.

We put cash and money market into a category called “Short Money.” This category includes anything that matures in less than two years. Short Money, U.S. Bonds, and Foreign Bonds are the three asset categories that provide a portfolio with stability. Like the iron rods they put in sailing ships to keep them upright in stormy weather, these three categories keep your portfolio upright in stormy markets.

Fear can cause investors to place too much in these categories while greed can cause investors to put too much in higher-risk investments. Greed and fear are both harmful to meeting your investment goals. Our suggestion is to invest whatever you might be spending in the next 5-7 years in the stability of fixed income and invest the remainder in appreciating stocks.

5. You need to have liquidity for investment transactions.

Even in your investment account you may want to keep a portion in money market. Free cash is needed for transactions and periodic rebalancing. For example, when the markets drop, it is nice to have some cash ready to use for purchasing more market investments at the lower prices.

If you are holding cash simply because it is building up in your checking account then you should consider implementing an automatic saving and investing process. We have several articles on the topic, including “The Complete Guide to Automating Your Savings,” which can guide you through how to do this.

By adjusting your savings strategy, you will be able to keep free cash in your checking account to a minimum and put all of your money to work in a well-balanced investment strategy.

The original version of this article was published October 20, 2003. Photo used here under Flickr Creative Commons.

Follow David John Marotta:

President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.

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Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. She is the author of over 800 financial articles and is known for her expertise on tax planning.