How much should I have in savings? Do I have enough? Too much? Where should I keep it? Why should I have cash savings rather than investing my money so it can be working for me?
These are some questions clients frequently ask about cash reserve accounts.
Most people know, intellectually, that it is important to have liquidity (readily available cash). It’s harder to grasp how much is appropriate. Determining a target is an individualized exercise, though, and not as straightforward as some might believe.
Ask yourself three different questions:
What amount of liquidity will allow you to sleep easily?
If you lost your job or your portfolio declined by 10% or 20% how much cash in a bank account would be sufficient to prevent you from unbearable worry?
If you had to cover your expenses from your savings, how many months of expenses could you support?
If you had to support only your basic, necessary expenses, could you cover three months? Six months? A year? Many personal finance writers suggest you have 3-6 months of necessary expenses.
If your dream opportunity (job, house, trip, car) arose, how much cash would you need to be able to jump on it?
You can look at liquidity not just from the perspective of emergencies, but also from the angle of opportunities. Would it cost you $10,000 to move? $1,000 to fly to Europe? $60,000 for a down-payment?
After you have spent some time with these questions, set a goal for your liquid savings.
Your individual target should take into consideration your ratio of necessary and discretionary expenses. Look at your expected loan payments, your availability of credit (both cards and home equity lines), and a reasonable estimate the likelihood of loss of employment income in an economic downturn.
If you are a retiree, consider what reliable income you have coming from Social Security and pensions. If you have a pension, consider the solvency of the pension fund and the total coverage offered by the Pension Benefits Guarantee Corporation (PBGC).
Through reflection and analysis, you can arrive at a target – either stated as a dollar amount or as a number of months of fixed expenses.
Keep your savings separate.
Once you have an objective, decide on where you will keep your liquid savings and when you will aim to achieve your savings goal. A significant portion of your liquid savings should be in cash savings (savings accounts, money market accounts, or CDs with minimal early withdrawal penalties). While you will not be earning a lot of (if any) interest in these accounts, the forgone interest is the price you pay for the security provided by having readily available cash.
Liquid savings should be held separately from long-term investments and your short-term operating cash. Such mental accounting will aid you in not “raiding” your savings for non-critical expenses.
Make peace of mind a priority.
Liquidity. Emergency account. Rainy day fund. Whatever you call it, it is there to give you peace of mind that you can continue to live your life in the face of a crisis or opportunity. Make it a priority.