Getting financially fit--and staying that way--isn't something you can knock off on a Saturday morning. Rather, like any worthwhile project, it's a goal that's best accomplished as a series of smaller steps. Unexpected expenses can crop up no matter your life stage, making it essential to hold liquid reserves--apart from your long-term retirement assets--to defray them. On the docket for May: right-sizing your cash cushion.
But how much cash is enough? That's more complicated than it sounds. While the financial-planning textbooks suggest that people stash three to six months worth of living expenses in true cash instruments, the right amount of cash varies by individual; life stage, career type, and access to other sources of liquidity, among other factors, all play roles.As you assess your cash holdings and determine the appropriate allocation, here are 4 questions to ask.
Question 1: What is your life stage?
The key swing factor in determining your cash allocation is whether you're still working or retired. If you're still working, the main role of your cash cushion is to tide you through job loss. Secondarily, you'll want to hold cash so that unanticipated expenses don't force you to raid your long-term assets--or turn to unattractive forms of financing like credit cards--to meet your living expenses. It's reasonable to use three to six months worth of living expenses as a starting point when setting your cash allocation. You can then refine that number based on your estimation of how long it would take you to replace your job and so on.
If you're retired, the threat of job loss is obviously no longer an issue. But it's still wise to hold a cash cushion. Unanticipated expenses like emergency car repairs and big vet bills can crop up in retirement just as they did while you were working, and it would be a shame to have to raid your long-term investments to cover them. More important, retirees need to hold cash to tide them through downturns in their long-term portfolios. Knowing that their near-term income needs are covered can also help retirees ride out volatile times with their long-term portfolios.
Question 2: Are you the sole earner in your household?
If another person in your household is earning an income and contributing to the expenses, that means that you have more of a buffer in case of a job loss than does someone who's the sole earner in his or her household. Thus, your emergency fund needn't be as large as is the case for individuals who are the sole earners in their households.
Sole earners whose employers provide a healthy stipend toward healthcare expenses will want to be especially cautious on the emergency-fund front. Not only would they need to use their emergency fund to cover household expenses if they lost their jobs, but they would also need to accommodate higher outlays for healthcare insurance, deductibles, and so forth.
Question3: How much wiggle room do you have in your household expenses?
Is your budget tilted toward fixed or discretionary expenses? If more than 50% of your income goes toward non-negotiables like your mortgage, car payments, tuition payments and the like, you'll need to maintain a higher allocation to cash holdings than would be the case if your fixed monthly outlays are a smaller share of your budget.
From this standpoint, middle-career workers need to be especially careful. Workers just starting out are less likely to have taken on mortgages and car payments, and may also be more flexible in their lifestyle choices. Some older workers, meanwhile, may be close to paying off their mortgages. If they purchased their homes a few decades ago, their housing outlays may be lower than is the case for those who have purchased within the past five to 10 years.
Question 4: Do you derive peace of mind from holding cash?
The aforementioned questions all relate to an investor's emergency-fund needs. But what about cash as a want--to provide peace of mind, for example? As financial-planning guru Michael Kitces explores that investors might derive a sense of contentment from holding cash reserves above and beyond what they actually need to hold as an emergency-fund cushion. Of course, cash is earning next to nothing now, so investors shouldn't go overboard with lush cash holdings. But if holding more than the bare minimum of emergency cash provides peace of mind and financial contentment, that's nothing to sneeze at.