The Happiest Place on Earth
It’s funny how some childhood memories just seem to be branded into my memory, regardless of their significance or relevance. One memory that comes to mind is this image of this 5-gallon jug that lived next to the front door at my friend’s house. Upon my first introduction to the jug, it was empty and lonely, sitting there without a purpose. I just assumed the jug was heading to the recycle bin when someone got distracted and set it down. Upon my next visit, the jug was still there, but now it was littered with some coins, which got me curious. I came to find out that this was meant to be an oversized piggy bank, and the goal was to fill it up with change that the family would eventually use for a Disneyland trip. As you might imagine, 10-year-old me would regularly check the status of this money jug and watch as what was once empty became a weighty bucket of spare change.
The Squirrel Principle
This is how humans operate, right? We just love to squirrel away cash, as it gives us a sense of security (1) knowing that this cash exists and (2) that this money is easily accessible. Now, I doubt any of you have that 5-gallon piggy bank at home, but the principle here still applies; whether at one bank or many, you have some cash squirreled away. Here’s one primary difference though, the 5-gallon jug is only 5 gallons, so there are limitations to exactly how much cash you can stuff in there. Your bank does not share these same limitations, your bank is happy to store as much cash as you are interested in parking there.
I sat in a presentation this week and an interesting statistic jumped out to me. The presenter noted that in the category of “High Net Worth” individuals, the average investor has about 20% of their liquid net worth in cash. So, basically, an individual with $2 million to $3 million typically has $400,000 to $600,000 in cash. There is a simple conclusion to be had here – that sort of cash set aside could cover a lot of Disneyland trips 🙂
The Goldilocks Principle
So, what is the right number? How much cash should one have?
Well, let’s answer this question by breaking down some of the pros and cons of cash; then, we can use these strengths and weaknesses to define how cash is best used and allocated.
Two of the greatest strengths of cash are that (1) the price is stable and (2) it is easily accessible – you can easily access funds and use them to purchase goods and services. What’s the downside to cash? The primary downside is that the goods and services you want to exchange for your cash are increasing in price while your cash is not commensurately increasing in value – this is the inflation problem. So, the conclusion here is that cash is an attractive solution for near-term expenses and emergency expenses, not so much for long-term wealth accumulation.
When trying to calibrate your cash need, you want to first start by looking out 24-36 months (near term) and see if you can identify any out-of-the-ordinary expenses. This would be a new car, a new roof, a big vacation, a wedding, a home purchase, etc. Whatever those definable near-term expenses add up to be, you should definitely have that amount set aside in cash. Note I am using the term cash here loosely, and something like a money market, high-yield savings, short-term CD or treasury, could be used synonymously.
Next, there are those near-term expenses that are unforeseen. Things like surprise medical expenses, a car accident, or any other curve ball life might throw your way. We need to account for these expenses, too, which is why having some emergency fund or safety net is so key to prudent financial planning. For me, I like to use this concept of layering and ensure that I have multiple layers of safety nets to protect against the unforeseen. I like to measure each “layer” as a multiple of my monthly expenses. So, I might have 6-months of my expenses in my normal checking/savings account, then another year or two of expenses in some high-quality bonds within my investment portfolio, then sufficient capacity in lines of credit (investment and/or home equity) to make up another handful of years worth of coverage of my expenses. I always want to relate these “layers” back to my annual expenses to get a sense of security on how strong each layer of this safety net actually is. A highlight here is that a safety net is defined as a resource that has all three of these qualities: reliable, stable, and accessible – locking up my money in an investment product that I can’t easily access would be like a fire exit that is locked from the outside, not a sufficient solution for one of these layers.
The Overflow
Most investors I go through this exercise with – taking inventory of their cash – will reveal that they have a surplus or overflow of cash. The typical reaction from folks will be that “this is a good problem to have,” and they will emphasize the security they feel based on the fact that this surplus exists.
This reaction makes sense to me. We live in an uncertain world, and this uncertainty isn’t represented anywhere better than the stock market. Investors have had to endure the ups and downs of the market, everything from the Dot Com Bubble to the Great Recession to COVID. So, the natural reaction is to have more than enough cash, a Dramamine of sorts for investors.
Here’s the problem, most people are unaware of this silent war happening in the background. Each and every day, the prices of our desired goods and services are creeping higher, ever so slightly, so as to not be obvious to the untrained eye. Warren Buffett describes inflation this way, “It [inflation] swindles almost everybody.” It’s that little swindler that is gnawing away at your buying power like termites.
Sticking with our “silent war” analogy, cash does play a crucial role as the medic. You need all hands-on deck to tend to the wounded – those surprise expenses and emergencies that do arise. Just as important though, you also need folks on the front lines and in the trenches doing battle with inflation. You can’t put medics on the front line; historically, cash has been annihilated by inflation, hence the need for stocks and other risk assets to do the hand-to-hand combat with inflation.
Right Sizing Your Cash
So, what happens when you do right size your cash allocations based on your near-term expenses and sufficient emergency coverage? Essentially, you create leeway to add to your investments that have a greater long-term expected return.
Just like inflation can be hard to spot based on its modest yet relentless moves higher, small increases in long-term rates of return are also very underappreciated. Let’s say that when taking inventory of your cash, you execute some reallocations that increase your rate of return by 1%. This might seem insignificant, but this change ever so slightly increases the slope of how your wealth will grow, which over the long term will often be the difference of millions of dollars.
Here’s the goal: you want the slope and trajectory (growth) of your wealth to be steeper than the slope and trajectory of your spending. The widening gap between those two lines should be the real financial security you seek. As your balance sheet grows and overshadows your spending, you are essentially reducing risk. In financial planning, we most commonly address the risk of an investor potentially outliving their nest egg. We, as financial planners, depend heavily on withdrawal rates as a metric for measuring this risk. So, what are the inputs for calculating a withdrawal rate? Essentially, your spending divided by your nest egg. Again, over the long run, increasing your assumed growth rates will create the security and de-risking you desire.
Where It All Starts
Like most things in personal finance, this all starts with awareness. You need to know where you stand today and determine if any adjustments need to be made. You need to take inventory of your cash and measure those allocations as a multiple of your expenses. You can then right-size those allocations and increase your infantry to do battle with inflation.
This is a good exercise to do alongside your advisor. Often, this will also allow you to consolidate and simplify your accounts. In the same way that our garages just seem to naturally accumulate stuff over time, we also tend to accumulate accounts and banking relationships. More relationships means more logins and potential for errors in how things are titled and/or how beneficiaries are listed. Trust me, taking inventory here will be a worthwhile endeavor.
As always, follow-up questions are welcome – you know where to find me…
