The Right Amount of Liquidity

Planning Reflection | July 16, 2021

A question we often hear from our clients is, “How much cash should I have at the bank?” On the surface, this seems to be a straightforward question that should have a straightforward answer. However, as with many things in personal finance, the answer depends on your circumstances and needs.
 
Before we dive in, let’s first discuss cash itself. Cash is an asset that is available to spend on short notice, and that you can count on to hold its value in the short term. “Short term” is the key here, because inflation gradually and invisibly chips away at the value of cash over time. $1,000 today doesn’t buy what it used to 30 years ago, and the same pattern will likely continue going forward.

A commonly cited heuristic says that you should keep three to six months’ worth of expenses in cash. Three months if you have multiple independent sources of income, six months if you have one source of income. Even with multiple streams of income, other factors can nudge you toward the more conservative option. If you have minor children or dependents, or if you work in an industry with seasonal or unpredictable work, you might err on the side of more cash.
 
This approach specifically refers to an emergency fund, that is, a pool of resources you can draw on to support yourself temporarily should you lose your job. If your savings can’t bridge a gap between jobs, saving enough to do so should be one of your highest financial priorities. An emergency fund can also be used for unexpected expenses, but whenever you use funds from it, you should work to replenish them.
 
As with all heuristics, this is good general advice, but it doesn’t take into account anyone’s specific situation.

Once you have enough cash saved to cover short-term cash needs, your options start to open up. Some people prefer to keep extra cash at the bank to get to a higher tier of service – better rates on loans, more perks on your credit card, and so on. Others keep extra cash as a sort of opportunity fund, letting them pounce on fun things that come up without worrying about how to pay for them. Having more cash on hand, a “just in case” fund, can also promote peace of mind even if there’s no expectation of using it.
 
There are other instances where it makes sense to hold more cash than you normally would. Buying a home is a common example. If you’re planning to buy a $1,000,000 home with a 20% down payment, you’ll need to provide $200,000 in cash (plus closing costs) at close of escrow. Even if you haven’t identified a house yet, it can make sense to keep the down payment in cash to ensure those funds are available when you need them.
 
As you build wealth over time, you start to develop a portfolio of investments beyond cash, which provides other options for funding your financial needs. Liquidity – the ability to quickly convert an asset into cash – covers a wide spectrum. Cash is clearly on one end (you don’t need to convert cash into cash), with highly illiquid private investments on the other end. In between, there are CDs, bonds, stocks, commodities, real estate, and more, all of which have different features.

Our clients’ portfolios contain many of these different kinds of investments, raising the question of where to draw funds when there’s a cash need.  Smaller needs, like an unexpected $2,000 car repair, can usually come from your cash at the bank. Larger needs, whether expected or unexpected, can be drawn tactically from your investments. Our work often involves navigating these decisions, incorporating market fluctuation, taxes, legacy concerns, and myriad other considerations that can influence the best place to draw funds.
 
Many things can affect the “right” amount of cash to have on hand. In our conversations with clients, we often boil it down to another heuristic: as long as you’re meeting your basic needs, the right amount is the number that feels good to you. If there’s too much or too little, you’ll know.