The hardest part of mastering your finances often starts with turning your finances around.
Most Americans live beyond their means and have incurred a substantial amount of debt in the process.
Getting out of debt is a struggle for many, but once you turn the corner there are still many financial sinkholes you can fall into.
After fighting to get out of debt most people turn toward saving up for a full sized emergency fund while simultaneously investing for retirement.
However, after your emergency fund goals are met, most people continue to save in a checking or savings account rather than ramping up their investments.
That could be a major mistake.
Cash & Saving Accounts – Not Awesome For All Of Your Money
First off, cash and savings accounts are awesome.
Both physical cash and savings accounts allow you to get at your money immediately, or at least very close to immediately, when you need it.
The instant availability of cash is the exact reason I suggest everyone have an emergency fund kept in cash or a checking or savings account.
Unfortunately, once you get past your emergency fund and any other short term to medium term goals, you shouldn’t be keeping your money in cash. Sadly, it just won’t help you grow your wealth. If anything, it may actually erode your wealth.
Confused? Here’s exactly how cash can erode your wealth over time.
Inflation – The Stealthy Enemy Of Cash
Inflation is the reason you should start investing and shouldn’t keep all of your extra money in cash. Basically, inflation is the concept that explains why a candy bar cost a nickel decades ago and costs almost a dollar today. Over time, a dollar will buy less as its real value decreases.
Rather than trying to understand why inflation happens, you should just accept the fact that inflation happens and move on. The why of inflation is extremely complicated and not really worth worrying about.
You should only worry about what you can control, and that’s making sure you don’t lose money over the long term after you account for inflation. If you leave your money sitting in cash, a checking account or a savings account, you won’t be able to keep up with inflation.
Why You Lose Money With Cash Due To Inflation
Today, you’re lucky if you can find a savings account with an interest rate of just 1%. From the period of 1914 to 2015, inflation has averaged 3.32% per year.
As you can see, earning 1% in a savings account or earning 0% on your cash under your mattress won’t help your money keep its real value based on the average inflation rate over the last 100 years.
Over time, this effect will compound causing you to lose even more money due to inflation. If you had a dollar back when candy bars were 5 cents a piece, you could have bought 20 candy bars. If you kept that $1 in your wallet until today, you’d only be able to buy one or two candy bars if you’re lucky.
In order to keep up or even beat inflation, you have to invest in something that will have average returns that beat inflation over the long run. In general, this requires taking on more risk than leaving your money in cash.
How Much Cash Should You Have
So now that we know we don’t want to keep all of our extra money in cash because it will lose buying power to inflation over time, how much cash should you have?
This will vary greatly from person to person, but here are a few rules of thumb to keep in mind when considering how much cash to keep on hand or in a savings account.
First, you need an emergency fund. Assuming you have all of your high interest rate debt paid off, I usually recommend having an emergency fund that varies anywhere from three to twelve months of your expenses, not income.
If you live in a dual income family with no dependents and have stable jobs, three months worth of expenses may cover you. However, if you’re self-employed and have three dependents, you may want to keep as much as twelve months worth of expenses in cash.
In addition to an emergency fund, there are other good uses for cash. For instance, if you have a short or mid-term goal that you absolutely need to accomplish, your money for those goals should be in cash.
Why? You don’t want to take the risk of not having the money when you need it and any investment that outpaces inflation comes with the risk of losing money in the short to mid-term.
Personally, for any goal in the one to five-year range, you should keep your money in cash unless you’re comfortable with delaying the goal until your investments have time to recover after a downturn.
Finally, cash does have its place as a small part of an investment portfolio. Having a small amount of cash on hand allows you to take advantage when investments drop in price in a downturn.
I wouldn’t keep any more than five percent of your investment portfolio in cash, but every person’s situation is unique. Even then, keeping cash in an investment portfolio is an advanced level investing philosophy, so if you aren’t comfortable with the idea, just dollar cost average your investments over time and you’ll likely be fine.
So as a recap, you should keep the following in cash at a maximum:
- three to twelve months worth of cash for an emergency fund,
- enough cash for any must complete goals one to five years in the future, and
- five percent of your investment portfolio.
What should you do with the rest of your money? Invest it!
Start Investing Everything Else
The key to growing wealth is having the discipline to invest any money above the cash amounts you’ve decided on above.
If you haven’t maxed out your retirement accounts, those may be a good option to stash away your additional investment money. These accounts could include your 401(k), 403(b), thrift savings plan or their Roth versions at work, or another type of retirement account such as an IRA or Roth IRA.
Another option is a regular taxable investment account. You can open these at brokerages such as Vanguard, Fidelity or any other investment brokerage.
No matter where you decide to invest, please make sure that your default investment in these accounts is not cash. Just storing cash in an investment account won’t accomplish anything at all. You need to pick an investment.
Advanced investors may choose to invest in other areas besides investment accounts. You could easily spend money investing in yourself and your future earning potential. If you run a business, investing in your business may provide the best potential future return. You could even invest in rental properties if you wanted to.
The options are endless, but the key is that you invest your excess money and don’t leave it in cash.
How To Pick Paper Investments
If you’ve decided to invest in paper investments, such as mutual funds or index funds through a retirement or taxable investment account, you’ll need to pick an investment. The first thing you should do is decide when you’ll need access to the money.
Based on that time frame, you should pick an investment that is suitable for your time frame. If you won’t need the money until you retire 30 to 40 years from now, you can be more aggressive in your investments. If you’ll need it when you retire in 10 years, you’ll probably want to be more conservative with your investments.
When you’re investing, make sure you look at the costs of your investments. Personally, I only invest in low-cost index funds when I’m dealing with paper investments. The difference of investment fees of just one percent a year can make a huge difference in your ending balance over decades of investing.
Pay attention to fees.
Take A Look At Your Full Financial Picture
Now that you’re finally ready to take action and start investing that excess money, you’ll need to take a full look at your full financial picture to figure out how much you should invest. Personally, I recommend Personal Capital as a way to look at all of your financial accounts in one place.
Their tools are awesome and allow you to determine how much cash you have in total, all in one place. All you have to do is sign up for a free account and link all of your financial accounts.
If you’re wondering if Personal Capital is safe, we’ve found that they generally are. They use bank level, military-grade encryption and only have read access to your accounts, so you don’t need to worry about linking your accounts.
Added Bonus: If you have total investable assets of over $100,000, Personal Capital will set you up with a free phone call with one of their financial advisors. It is totally optional though, so you don’t have to take the call if you don’t want to.
Once you’re logged in and have linked all of your accounts with Personal Capital, simply hover over the accounts menu at the top of the page and click on Dashboard.
On the left-hand side of the page, you’ll see a listing of all of your accounts. At the top of this menu, you’ll see a section that totals up all of your cash that isn’t in investment accounts.
In addition to your cash accounts, you’ll also have cash as a part of your investments.
To see how much of your investments are in cash, scroll to the bottom of your dashboard to the portfolio allocation section. You can hover over the label cash or the green section in the graphic to see how much cash you have in investments.
Add the cash from investments to the cash in your my accounts section and you’ll have the total amount of cash you have in your finances.
Keep in mind, any cash in your investments could be in a mutual fund and may not be immediately accessible to you. Include any cash in your investments as part of the up to five percent your investment portfolio.
How Much Of Your Assets Are Cash? Is That Too Much?
Now that you have looked at your whole financial picture in one spot, do you have too much of your overall money in cash? If so, begin making a plan on how you want to move that money from cash into investments.
At the same time, you’ll want to figure out how much money you’ll need to invest, rather than save, each month to make sure your cash doesn’t start creeping up again in the future.
Of course, if you don’t have enough cash yet, make sure you keep saving until you do have enough. However, don’t make saving your sole goal. You’ll need to continue investing for retirement and taking care of any other goals or financial issues, such as high interest rate debt, that you may have.
Cash Is Important – Just Don’t Have Too Much
Cash, savings accounts and checking accounts all have a place in anyone’s financial lives. Just don’t hoard cash and keep saving because you’re afraid to invest.
Inflation will slowly erode your purchasing power and without the compounding returns on investments other than cash, you may never be able to retire or meet your other financial goals.
Make a cash plan and stick to it and you’ll be well on your way to growing your wealth.
How much cash do you think is too much? Have you made it to the point in your life where you’ve started to invest more of your money rather than just save cash? Or are you still trying to fill your emergency fund and the needs of your short term goals? Let me know your thoughts in the comments below!
Disclosure: If you sign up for Personal Capital through one of the links in this post, I will get a small commission if you link more than $100,000 in investable assets. There is no cost at all for you to sign up for Personal Capital’s free tools, but we do appreciate if you do so through our links. As always, I only promote products I believe in or use myself.
Lance Cothern, CPA holds a CPA license in Indiana. He’s a personal finance, debt and credit expert that writes professionally for top-tier publications including U.S. News & World Report, Forbes, Investopedia, Credit Karma, Business Insider and more.
Additionally, his expertise has been featured on Yahoo, MSN, USA Today, Reader’s Digest, The Huffington Post, Fast Company, Kiplinger, Reuters, CNBC and more.
Lance is the founder of Money Manifesto. He started writing about money and helping people solve their financial problems in 2012. You can read more about him and find links to his other work and media mentions here.