What's the Right Amount of Cash?
How much cash to hold is a very common question with important financial implications.
- Hold too much cash and you are likely losing to inflation and you are not earning as much as you reasonably could.
- Hold too little cash and you risk being forced into selling your investments at an inopportune time or even going into debt.
Let's dive into why it's crucial to find the right balance and how you can determine the perfect amount for your situation.
What’s wrong with too much cash?
While it’s always comforting to have adequate cash, there are costs to holding too much.
Keeping excessive cash can hurt your financial health in three sneaky ways:
- Inflation Erosion: Over time, the purchasing power of your money decreases due to inflation. Since 1985, cash has barely kept pace with inflation, and in recent years, it's actually lost ground.
- Missed Opportunities: By not investing, you could be missing out on potential returns. Historically, diversified investment portfolios have outperformed cash over the long term.
- Tax Inefficiency: Interest from savings accounts is taxed as ordinary income, which can be higher than taxes on long-term investment gains.
Inflation
The first cost of holding too much cash is inflation. Since 1985, cash rates and inflation have had very similar rates of return, with cash slightly outpacing inflation. Cash has returned an annualized 3.3% per year while inflation has averaged 2.8% per year over this period.
Cash is approximated by the 3-month Treasury Bill rate. CPI is the Consumer Price Index for All Urban Consumers.
Although cash has held its value relative to inflation since 1985, nearly all of that real growth came before the 2000s. Below is an inflation-adjusted chart of the growth of cash since 1985.
As you can see, cash generally earned rates above inflation between 1985 to the early 2000s. Then cash began to lose value to inflation in the first decade of the 2000s until inflation crashed during the global financial crisis. After the crisis, savings account rates were kept near 0% during the 2010s and cash has lost a lot of purchasing power relative to inflation.
Opportunity Cost
The opportunity cost of holding too much cash is the higher returns your money could have earned through investing.
Below is data for several major asset classes from May 1996 through 2024 (data is limited by the history of one of the funds). The asset classes include proxies for U.S. stocks, international stocks, Treasury bonds, gold, and cash.
Each investment asset outperformed cash over this time period and some by a significant margin. Stocks, bonds, and gold also outperformed inflation over this period while cash lost purchasing power.
However, it is of course imperative to call out that this data covers a nearly 30-year time frame and each of these asset classes has been subject to major declines and long underwater periods since 1996.
It is not as easy as selecting an investment and outperforming cash over a given 3-, 5-, or even 10-year time horizon.
Below are rolling returns for stocks, bonds, gold, and cash from 1996 through 2024. Each of these major asset classes experienced 7-year periods with negative returns (before inflation) and both stocks and gold experienced 10-year periods with a negative return (again, before inflation).
Although an individual asset class can’t be expected to produce positive returns even over a decade-long time horizon, by combining assets in a diversified portfolio an investor can increase their batting average compared to cash and inflation.
A risk parity-style investment approach combines stocks, bonds, and alternatives (like gold) for a robust portfolio designed to weather many different economic environments. Historically this type of portfolio has outperformed cash by a significant margin, but without the deep and long underwater periods of any individual asset class.
This simple risk parity-style portfolio’s worst 3-year return was an annualized -0.5% (compared to -17% per year for global stocks, -15% per year for gold, and -5% per year for bonds). The graph below compares rolling 3-year returns of the risk parity-style portfolio (blue) to cash (red). The risk parity-style approach has demonstrated a very high batting average relative to cash.
As an investor stretches their time horizon, the greater the likelihood an investment portfolio will outperform cash. Below is the same data with rolling 5-year periods.
The risk-parity style portfolio has outperformed cash in nearly every 5-year window and has never experienced a negative return.
The opportunity cost of holding too much cash is the returns of a diversified investment portfolio that an individual could have earned in excess of the cash return.
Taxes
The third cost of holding too much cash is taxes. Interest from savings accounts is taxable as ordinary income, which is reported to you via form 1099-INT and reported on your 1040 on line 2b.
Today's high-yield savings account rates of around 4% may appear attractive, but that's a pre-tax return. If your marginal tax rate is 25%, your after-tax return is closer to 3%.
Investment income on tax-advantaged accounts (401(k)s, IRAs, HSAs, 529s) is not taxable in the year incurred, reducing tax drag and effectively allowing you to compound your money at a faster rate. And even in a taxable brokerage account, securities held for greater than one year are subject to preferential (lower) capital gains tax rates compared to the ordinary income tax rates applied to bank interest income.
How much cash should I hold?
Although the "correct" amount of cash is household-specific, the below framework aims to identify a reasonable amount of cash above which a household may consider investing. The framework can be visualized as cascading buckets. Once your cash buckets (buckets 1-4) have been "filled," then any excess may be invested depending on your household's priorities.
- Cash Flow Account: 1-2 months of expenses in your checking account
- Emergency Fund: 3-6 months of expenses in a high-yield savings account
- Non-Monthly Expenses: 50% of anticipated irregular expenses (e.g., travel, home maintenance)
- Short-term Goals: Funds for goals within the next 3 years
- Investments: Any excess cash above these buckets
Bucket 1 is held in a checking account, buckets 2-4 are held in a high-yield savings account, and bucket 5 represents various investment accounts and goals.
Cash Flow Account
The "Cash Flow" account is your main checking account subject to your regular inflows and outflows. This is where your paychecks are deposited and your bills are paid.
In thinking about your bucket 1 target amount, you're trying to strike a balance between keeping enough in the account to avoid overdrawing and not keeping too much, as these checking accounts rarely pay much (or any) interest. With one to two months worth of expenses, you shouldn't need to check in on this account balance more than once a month.
Emergency Fund
At a minimum, I recommend keeping 3 months of expenses as an emergency fund. But depending on your personal circumstances (employment, family, etc.) and preferences, this could be 6 months or more.
This bucket is meant purely for emergencies and ideally is never, or very rarely, dipped into.
Non-Monthly Expenses
Also in a high-yield savings account, I recommend targeting 50% of your "non-monthly" expenses or goals. These expenses include things like travel, homeowners insurance, home maintenance, medical expenses. These are expenses and goals that are likely to be due during the year, but will be infrequent.
By setting aside funds in this account, you should avoid dipping into your emergency fund for these annual outflows.
Short-term Goals
The last component of savings in a high-yield savings account is short-term goals, or big goals with a time horizon of three years or less. These goals could be a down payment, a new car, or renovations to your home.
As noted earlier, in less than three years even a well-diversified portfolio's returns are highly uncertain. If the time horizon is 3 years or more, you may consider investing for these goals.
Investment Accounts
If each of your first four buckets are full, you may allocate any excess to an investment account. This could be a taxable brokerage account, or additional savings in a tax-advantaged account like a 529, HSA, IRA.
You could also invest more in your 401(k) or employer-sponsored plan, but savings in these accounts must often come as a payroll deduction and requires more planning ahead of time. If you regularly find yourself with extra cash beyond your buckets, you could consider increasing your retirement deferral rates through your employer.
Setting Up Your Buckets
The bucket strategy requires two main types of accounts: a checking account and a high-yield savings account. These accounts could be held at the same bank but are more often held at different institutions and then linked to easily move money back and forth.
I generally recommend maintaining a checking account at a "brick-and-mortar" bank and a high-yield savings account at an online bank.
Brick-and-Mortar Bank
A "brick-and-mortar" bank is a bank with a physical location that is convenient for you to access. These banks offer valuable in-person services, like handling cash, cashier's checks, and notary services. However, these types of banks tend to offer lower savings rates than online high-yield savings accounts.
The "Cash Flow" bucket (bucket 1) is a good candidate for your brick-and-mortar banking relationship.
Online High-Yield Savings Account (HYSA)
High-yield savings accounts offer competitive interest rates but lack the in-person services available at brick-and-mortar banks.
Your emergency fund (bucket 2), non-monthly savings (bucket 3), and short-term goals (bucket 4) may be held in your HYSA. Some banks will even allow you to create "buckets" within your savings account to delineate the different goals of your cash.
You may try to find the highest-yielding savings account, but should also consider the technology, user interface, and customer service.
Investment Accounts
Your investment accounts represented by bucket 5 will vary based on your life stage and goals.
Once you have filled your first four buckets, you may opportunistically invest in these investment accounts. You may invest in a taxable brokerage account for intermediate-term goals or as a complement to your tax-advantaged savings. Or you may choose to make investments or add to your automated investments in your tax-advantaged accounts (IRAs, HSAs, 529s, or self-employed retirement accounts).
Striking the Right Balance
By following this framework, you can:
- Ensure you have enough cash for immediate needs and emergencies
- Avoid the hidden costs of holding too much cash
- Potentially increase your long-term wealth through strategic investing
Remember, your ideal cash balance may change over time. Review your buckets monthly and adjust as your circumstances evolve. With practice, you'll find the right balance between financial security and growth potential.
Finding your cash sweet spot might feel challenging at first, but it's a crucial step towards financial well-being. By optimizing your cash holdings, you're setting yourself up for a more secure and prosperous financial future.
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