The Right Amount of Liquidity

Planning Reflection | March 24, 2023

A question we often hear from our clients is, “How much cash should I have at the bank?” On the surface, this seems like a straightforward question that should have a simple answer. Recent trends – ranging from inflation, to rising interest rates, to the unanticipated fragility of regional banks – have instead highlighted the complexities involved in managing personal cash reserves.

In light of this, we have updated an article we originally published in July 2021, to offer insight on how to think about cash and cash reserves. 

Cash is an asset that is intended to be available to spend on short notice and that you can count on to hold its value in the short term. A commonly cited rule of thumb recommends keeping 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. Other factors can nudge you toward keeping even more cash, such as if you have dependents or if you work in a field with seasonal or unpredictable cash flow.

This approach specifically refers to an emergency fund that you can draw on for temporary support should you lose your income. 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 long as you have enough saved to cover short-term needs, you can decide how much additional cash you want on hand. 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. Having more cash on hand, a “just in case” fund, can promote peace of mind even if there’s no expectation of using it. More recently, higher interest rates have made it more attractive to keep larger cash balances.

Buying a home is a common example of an instance when it makes sense to hold more cash. 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. 

If you intend to keep a large amount of cash at the bank, whether short-term or longer-term, it’s crucial to pay attention to the FDIC insurance limits. The recent collapse of several regional banks has highlighted both the role and value of the FDIC, but it has always been a prudent practice to keep cash balances within the FDIC limit. Whenever you have more than $250,000 in cash, it’s worth ensuring that your cash is held in a way that is fully covered. This could mean working with multiple banks, having different types of accounts, or using a product that creates the same outcome. Our clients, for instance, have access to a money market fund that is FDIC insured up to $2,500,000.

As you build wealth over time, you may accumulate 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 range. On one end of the spectrum, cash is (usually) immediately available; on the other end, real estate or private investments may take months or years to sell. In between, there are CDs, bonds, stocks, commodities, and more.

While cash has begun paying meaningful interest over the past year, short-term interest rates are usually lower than the expected long-term appreciation in more growth-oriented investments and may not keep up with inflation. Interest rates on deposits can be volatile as well, and often the return on cash drops significantly during recessions. Longer-term, growth-oriented investments have historically been the best way to earn a return beyond inflation, and we expect this relationship will remain in the future.

Our clients’ assets include cash at the bank as well as longer-term investments, raising the question of where to draw funds when there’s a cash need. Smaller needs, like an unexpected car repair, can usually come from your cash at the bank. Larger needs, whether expected or unexpected, can be drawn from your investments. Our work often involves navigating these decisions, incorporating market fluctuation, taxes, legacy concerns, and 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 compare it to other financial decisions involving a trade-off between security, risk, and return. As long as you can meet both your day-to-day needs and small unexpected expenses, the right amount of cash is what feels right to you.