While we believe that making your money work for you is important, it is also important to hold some cash in checking and savings for emergencies. The idea, of course, is to hold enough cash to take care of those emergencies without being forced to sell your investments or take on debt. But how much is enough? A good rule of thumb is 3 to 6 months-worth of spending needs, but the best answer is ‘it depends.’ Here are some questions to guide you to the right answer given your situation.
1. What could happen?
Everyone needs to hold cash for those everyday emergencies. Sometimes there is simply a hospital bill or mechanic bill that needs to be paid. You should have enough cash in checking to field those expenses without reaching for the credit card, taking out a 401k loan, or being forced to wait until the next paycheck. It is tough to plan for everything, but this is where a base of 3 months of spending needs becomes a minimum.
2. How certain is your income?
If you work in a dynamic industry or are self-employed and your job future is uncertain or income at risk, then it is important to hold more money in cash. I think it is best to imagine that future event and consider how you would handle your finances. For example, how long will it take you to find a job? Six months? If so, then it is wise to hold 6-months-worth of spending. A year? Then perhaps even more savings would be appropriate. Conversely, if you are living off a pension and your income is very certain, then the need for these types of emergency funds are lessened.
3. Are you saving for a big expense?
If you are saving for a big expense, then it is wise to hold those funds in cash. For example, if you are setting aside funds to buy a $30,000 car within the next year, then those funds should be held in cash, and maybe in addition to your safety-net savings.
4. How liquid are your investments?
One important thing to consider is how quickly you could sell your investment portfolio if needed. For example, if all of your funds are locked-up in annuities, then holding more funds in cash would be wise. Conversely, if you have after-tax investment accounts that, if needed, could be sold, then holding more than 3 months of cash on hand may not be necessary.
If you have considered all of the above, and have significantly more cash than you would reasonably need, then it may be time to put some of the funds to work. That doesn’t mean that you need to put the money into the stock market. Holding bonds that pay a reasonable interest rate is a good alternative. Finding the right balance will keep you prepared for emergencies while moving you forward toward your goals.