This is an updated version of a post that I wrote in 2019. As interest rates have risen in 2022, I added some recent considerations for where to hold some cash.
Typically, a good financial plan will help you organize your money and cash flow so that you have cash available when you need it. Here are some important considerations as you grow your savings:
Set Your Liquidity Target
Liquidity means how much cash you have on hand to pay for things. I recommend having 3 to 9 months of net income accessible to you for an emergency situation. The key to this target is evaluating how much risk there is to your income. If you have a steady paycheck in a low turnover environment and there is not much risk to your cash flow, then you can get away with less cash (probably 3 months net income). If you are in a volatile industry, or worried about cutbacks, it is a good idea to have more of a cushion (probably 9 months). This money should be for when there is a threat to your cash flow or a significant expense that you can’t pay for out of cash flow. Everyone has different circumstances, but there are things that happen, that we just can’t plan for. That is life. When life happens, you typically need some cash.
Automate
The best way to build your savings is to automate. Pick an amount that you can set aside each month and have it automatically taken out of your account. This takes the decision-making out of the process. Once it is set up, you can increase your automated savings each year or whenever you have an increase in your income or a decrease in expenses (like paying off a debt).
Savings vs. Debt
The average American has $90,460 in debt[1]. Paying on debt typically is one of the most common challenges that we face as I work with people on building their cash savings. Many people feel overwhelmed by their debt payments and want to see progress on paying debt off before they save money.
While I agree that paying off debt should be the primary goal, I advise to not wait on building up savings. Life doesn’t really stop and wait, so typically there is always another major expense coming up. If you create a habit to add money periodically to savings along with paying off your debt, you often can reach your target goals sooner.
Where to Put Your Cash
I recommend keeping a comfortable amount in your bank in a savings or money market account. The amount of money you keep in cash provides peace of mind for your short-term needs and allows you to keep your long-term money invested during times when the markets are down. However, it is important to consider a few questions with your cash:
What is the interest rate that you are earning?
How accessible is the money when you need it?
How much access do you need to the money?
Is your principle protected from fluctuations?
Is there any type of insurance on your money?
This year, inflation has spiked to rates that we haven't seen in 40 years. With inflation at high levels, money that is left in cash for a long period of time may be losing purchasing power each year. Because of this, I typically recommend spreading cash among different instruments that will provide higher yields. Here are some financial tools to consider listed from higher liquidity/lower interest to lower liquidity/higher interest.
Bank savings accounts: typically accessible immediately and pay a very low yield
Bank money-market accounts: similar to a savings account but may pay a slightly higher yield.
High-yield savings accounts: These are online savings accounts that are liquid and FDIC insured and pay a higher yield that normal savings accounts. At Centered Financial, we provide access to a high-yield savings account through Betterment, but there are many banks to choose from. I recommend doing some research and choosing an account that provides the benefits that you need.
Money-market funds: These are typically associated as the cash position in a brokerage account, but can also be purchased directly. Money-market funds provide the stability of a money-market and higher yields, but lack FDIC insurance and guarantees on principle.
CDs: Pay a fixed interest rate and a guarantee of principle, but lack liquidity while the money is held for a term. The longer the term, the higher the interest that is paid. (Typically FDIC insured as CDs are provided by banks)
Short-duration bonds: Individual bonds can be purchased for varying terms much like a CD. There are different types of bonds, but they can generally be categorized as government or corporate bonds. We typically expect bonds to pay a higher yield than CDs because they have slightly higher credit and interest-rate risk. This means that you can experience small fluctuations to principle within bonds. As with CDs, a smart strategy is to ladder maturities so that access to the money is staggered and can be re-invested as interest rates change.
I-bonds: Government I-bonds have become popular lately as they carry an interest rate that is tied the the Consumer Price Index. These bonds are purchased directly through the treasury similar to savings bonds. There is a minimum holding period and a limit on how much can be purchased.
Short-term bond funds: Bond funds provide an investment in a managed portfolio of various bonds. These funds can be bought and sold each day, so there is a lot of liquidity. However, the value of your investment is determined by the underlying portfolio on a daily basis, so your money is subject to bond market risk.
Plan Ahead
It is smart to think about how much time you need to access money for your goals. You shouldn’t feel the need to cash out of investments because of market circumstances or income needs. I recommend planning 2-3 years in advance to access income from your portfolio. This means that you should keep money in cash for financial goals within 0-2 years. If you have goals beyond 2 years out, you should feel comfortable investing the money for a higher return, but be conscious of your risk. I typically recommend at least a 5 year time horizon for money to be put into risk assets like stocks.
Anything helps
What if you feel cash poor? Start now. Set a small goal to get one month of income in savings. Once you are there, celebrate your success and set a new goal. This is where a solid financial plan starts.
Centered Financial, LLC is a registered investment adviser offering advisory services in the State of California, Utah, Texas and in other jurisdictions where exempted. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the techniques, strategies, or investments discussed are suitable for all investors or will yield positive outcomes. To determine which strategies or investment(s) may be appropriate for you, consult your financial adviser prior to investing. Any discussion of strategies related to tax or legal planning is general and is not intended as tax or legal advice. Please consult appropriate tax and legal professionals for recommendations pertaining to your specific situation.
[1] https://www.debt.org/faqs/americans-in-debt/demographics/