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Paying down high-interest revolving debt, such as credit card debt, and building up cash reserves for emergencies are generally the first steps to getting your financial house in order. Financial advisors differ on how much cash you should have on hand, but virtually all say that it’s crucial to have an emergency fund before investing.
But interest rates have hovered near zero for most of the past seven years, meaning paltry returns for savings accounts. At the same time, equity markets have performed well, leaving many investors wondering if it wouldn’t be better to invest their cash reserves.
Do historically low returns for cash holdings change the logic that investors need to hold some cash?
The case for cash
Not so fast. The argument for creating an emergency fund before investing is well founded. A financial plan uses an investor’s current position and assumptions about the future to predict how to best address his or her long-term goals. But life is unpredictable.
Most of us are eventually faced with a considerable expense that we didn’t see coming or factor into our budget, such as a medical bill, a new roof, a new car or job loss. These expenses can completely derail your plans if you don’t have adequate savings.
For example, if you haven’t saved enough to cover a large medical bill, you might be forced to make a withdrawal from your 401(k). Or you might have to take on credit card debt, spending money on interest payments that you could have saved for other purposes.
The stock and bond markets are unpredictable as well, especially in the short term, which makes investing in them a poor alternative to keeping cash on the sidelines.
When you invest your emergency fund, you’re essentially trying to time the market, but you have no control over the timing. You can’t know in what direction the market will move and if or when you might need to liquidate your investments to access your emergency funds.
Even in years that produce positive returns, markets regularly experience corrections. If you plow your cash into the market but happen to need it during a correction, you lock in those losses. That’s why most people should be investing for the long term.
One of our clients recently decided to invest her cash reserves despite our protestations. When she completed her taxes in mid-January, she realized she would owe a considerable amount. Of course, in January the S&P 500 was experiencing the worst start to a year in history. Our client couldn’t stomach the risk that things might get worse and liquidated investments to pay her taxes and replenish her cash reserves.
The market subsequently rebounded, but she had already locked in fairly substantial losses because of the timing. This could have been avoided if she had held her reserves on the sidelines all along.
How much is enough?
How much should you keep in an emergency fund? That depends on your larger financial picture, such as the other forms of protection — namely insurance — you have in place. If you have no health insurance, no disability insurance or low amounts of home, auto or liability coverage, you’re at greater risk of needing to cover a sizable, unexpected expense, so you should hold more cash. But if you’re covered, your policies will kick in and you won’t need to draw as much on your own reserves in an emergency.
It also depends on how close you are to retirement and the shift from saving to spending down your retirement accounts. Retirees, particularly recent retirees, need to have a higher proportion of cash and conservative investments to help manage sequence risk. This is the risk that you receive low or negative returns early in retirement, decimating your nest egg and leaving you without enough time for it to recover.
Each person’s needs are different, but we generally recommend people who are still working save approximately six months’ worth of expenses, excluding taxes and savings. This is usually enough to cover an unexpected job loss, often the biggest threat to financial security. We recommend those who are about to enter or are in retirement have closer to three years’ worth of expenses saved. Three years is roughly the amount of time it takes to work through the average recession and recovery.
Cash is king
Lax monetary policy in the wake of the 2008-2009 recession has caused a period of persistent low interest rates, frustrating many savers and investors. It may or may not have helped stave off a 1920s style financial depression, but it has certainly put a strain on those in search of low-risk yield.
Cash offers a lousy return, but it’s impossible to overstate the importance of having enough in reserve. Without adequate cash holdings, you’re gambling, not investing. If you’re serious about maintaining discipline and giving yourself the best chance of achieving your long-term financial plans, it’s as true now as it has ever been: Cash is king.
This article also appears on Nasdaq.