The biggest financial mistake people make: Holding too much cash
April 29, 2022
From helping thousands of people make financial plans, we know that one of the biggest mistakes people make with their finances is holding too much cash.
It may feel safe to see large numbers in your checking or savings accounts, but, in reality, having too much cash can actually lower the chances of achieving your goals. Over the long-term, money in your bank account doesn’t generate enough return to keep up with inflation. In addition, to meet your financial goals, you need to make sure your hard-earned cash is working for you. The way to do this is to invest.
How much cash should I have on hand?
Obviously, you always need some cash immediately accessible. Your need for cash will be determined by three things:
How do I size my emergency fund?
We recommend that single-income families keep six months of living and housing expenses in a cash emergency fund, while dual-income households keep three months of expenses readily available in cash (since emergencies are less likely to impact both earners at the same time).
This buffer should be used to help you handle unexpected expenses and job loss without tapping into your retirement savings. Liquidating a brokerage account isn’t difficult, but having the cash you need on hand when an emergency occurs keeps an already stressful situation from getting even more complicated.
What about major purchases?
Knowing how much cash to keep on hand for major purchases is, frankly, challenging – and a big part of why we created Fortunately.
When purchases are distant, your money should be in high-growth investments like stocks. These have higher growth over the long-term but their value can change (sometimes dramatically) in the short-term. Since a distant purchase won’t require the money for some time, you can withstand the short-term price fluctuations and hang on for the long-term gains.
Conversely, when purchases are near, then you don’t want to keep your money in stocks. If you have an all-stock portfolio and the market crashes, you won’t be able to afford the house, car, or the college of your kids’ dreams.
To make the most of your money, you should invest for growth when a purchase is distant, and slowly transition to cash as it nears. This is done by following a glide path that reallocates your savings from stocks to cash over time. Figuring how much of your savings to allocate to each purchase and how to blend the glide paths can be a tricky math problem, but it’s one we do for you if you use Fortunately.
Holding cash is the wrong long-term decision
It may be tempting to just skip all that complexity and keep your money in cash, but doing so is incredibly damaging to your chances of achieving your goals. We’ve seen people improve their chance of having enough in retirement from 10% to 90% simply by investing their excess cash.
Why? Inflation causes your money to lose purchasing power over time. But even more significantly, the cash that is sitting in a bank account has an opportunity to grow in value - but only if it is invested. By investing your money in the stock market, you are able to take advantage of the power of compounding. A small amount invested now can be worth quite a lot later.
In addition, investing in the markets long-term is much less risky than you might think. Data shows that when investing over 20 years in a very conservative portfolio with 50% stocks and 50% bonds, even at worst you’d be 72% better off - but at best you’d be almost 450% better off. As you can see from our table below, that’s still tens of thousands in growth in the worst case historical scenario.
Regardless, don’t make the mistake of holding onto too much cash - especially if you’re just stuck about what to do next. Check out Fortunately and get started investing today.
April 29, 2022