Holding cash, also known as having savings, is an important building block for financial independence. But how much savings should you have? Well, this is going to depend on what you need it for. In this post I wanted to discuss 4 important uses for cash and how it can help you to determine how much cash you should hold.
Emergency money
Everyone needs emergency money to cover themselves for the random expensive things that life can throw at them such as a faulty hot water system or a sudden medical expense. One of the biggest risks that emergency money is required for is a job loss. I think that having 4 to 6 months’ worth of living expenses is a good starting point. At the FFE house, if we were to become unemployed, it’ll provide us with a decent amount of time to find work and it’s likely to be enough to cover a satisfactory proportion of large expenses that might unexpectedly appear.
Day to day expenses/buffering
Expenses can vary quite significantly month to month so it’s important to have enough cash to be able to cover household expenses month to month. At the FFE house our average spend is between $4000 to 5000 per month however our budget shows that in some months we have spent in excess of $10,000. Generally speaking, if you have between 4 to 6 months’ worth of living expenses saved then buffering day-to-day spending won’t be an issue, however it’s important to track your cash flow so that you can have more accurate picture of this.
If you are living off your portfolio, it’s likely that you’ll want more cash allow you to ride through portfolio fluctuations. In this case, even up to 3 years’ worth of living expenses would not be unwise. We’re still years away from having to live off our portfolio so this is something that I haven’t put a huge amount of thought towards, but it’ll definitely be a topic for future discussion.
Big expenses
I don’t think it’s financially responsible to consume a large proportion of your emergency money to fund discretionary expenditure; this is why it’s important to plan well in advance when looking to purchase something that’s expensive such as a car or home renovations. At the FFE house a large expense is something that will significantly affect our investing activities if unplanned for. This typically equates to purchase amount that is greater than 50% of our average monthly excess cashflow.
Here’s an example of how forecasting helps your financial situation: say you need $30,000 to purchase a car in 12 months. You bring home $9,000 per month; your cost of living is $4,000; and you typically invest $5,000 per month. Given your time frame you could save between $2,500 and $5,000 to achieve your goal. The choice of how much to save per month will likely depend on what opportunities you see in the market. If it was me in March 2020, I would have probably waited to save as there were such amazing stock market buying opportunities; but if this was March 2019 I would have more likely saved most of the excess cash and invested what was left over (for example, saved $4000 and invested $1000). The key point here is that the further in advance you can forecast large expenses the greater the level of flexibility you have to put yourself in strong financial position.
Investing opportunities
When it comes to passive investing, the general rule is that lump sum investing has a high probability of beating dollar cost averaging which is why we invest when our pay checks come in every month. For investors that choose a more active approach it’s important to have cash available to take advantage of opportunities as they arise. This amount depends in individual investor preference and what assets they are looking to buy, but once again, planning is key.
Putting this all together
Sometimes a picture speaks a thousand words, so for this article, how much cash you should hold can be summarized by the following diagram:
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