Cash Allocation in Portfolio Vs Cash Net WorthThis post will focus on how much net worth should be in cash as it relates to being able to cover all your monthly bills with ease, or in the event of job loss or an emergency. Note that this is different but closely related to how much cash to keep in your investment portfolio because your net worth includes your home and other assets. Both of these cash allocation topics are very important for managing your finances as well as managing risk while building wealth. Click here to read my related post What Percentage of Cash Should Be in My Portfolio?
Let’s Define Net Worth Cash FirstThis post considers cash as funds in money market accounts or similar funds which are highly liquid, accessible immediately and don’t fluctuate in value at all. Cash is also money on hand, or in a safe at your home. While you may keep some money in cash such as this, it is not earning interest. For most investors, “cash” is in some sort of money market mutual fund that invests in very short term debt and earns at least a tiny bit of interest. Net worth cash is usually kept in three places or accounts. First, most people have an account from which all the normal bills are paid. In the past, this was a checking account. Second, most people have an Emergency Account for unexpected expenses. Third, most people also have investment portfolio cash or money market funds. Again, this post will be more focused on the first cash two accounts but we’ll touch on investment cash since it is a factor for how much net worth should be in cash as you’ll see.
What Your Net Worth Cash Needs to CoverYou’ll want a percent of your net worth in cash so you’ll easily have funds to cover any expected or unexpected event listed below.
- Monthly Expenses
- Extraordinary Expenses
- Emergency Expenses
- Financial Crisis
- Job Loss
Lifestyle Expenses Vs Emergency FundsI like to call the first two expenses types above, Monthly and Extraordinary, lifestyle expenses since they are a function of where and how you live. It’s important to remember that you get to control these expenses since they are a function of your lifestyle even though it may not always feel like it. The last three expense categories qualify as financial emergencies. And, unfortunately, you will almost certainly incur at least one of the more severe unexpected events listed above at least once in your life. Jobs are lost, stock markets crash, divorces, and natural disasters all happen. The reality is that:
- Job loss is a very common event.
- Bear markets and recessions usually happen once or twice every decade.
- The divorce rate is about 50% which leads to suddenly needing two homes and savings accounts.
- And while natural disasters are less common, they happen.
5 Desired Outcomes of Allocating Enough Net Worth to CashThere are several reasons why estimating the right amount of your net worth to keep in cash is so important.
Financial Peace of MindFirst, paying your bills with ease allows you to avoid financing costs and feel at peace about your money. No one wants financial stress, and there is no reason to have it. By having enough of your net worth in cash, you’ll be able to get through financial crises, job losses and any other more severe situations. Not only this but knowing you can get through them will give you financial peace whether or not unfortunate financial events ever happen.
Avoidance of Undesirable DebtNot having enough of your net worth in cash can lead the need to borrow should you become financially strapped, resulting in high debt costs, poor credit, and even financial disaster.
Core Financial Planning and Investing GoalsCash management around your monthly living expenses is at the core of your retirement income planning. It tells you how much money you need to retire, which sets the goal for wealth building. Click here to read my post with the steps we take for simple retirement income planning.
Life EnjoymentHaving enough cash allows you to do things in life that make you happy. Let’s face it, in addition to being able to live, this is the ultimate goal of having money.
Strategic InvestingKeeping the right amount of net worth in cash is that it will alleviate having to sell investments when it’s best not to sell them. This is especially true when investments would need to be sold at a loss, or when selling an investment will trigger an undesirable capital gain tax at an already challenging time. And, ideally, you’ll have some of your net worth allocated to extra cash for investing when assets are cheaper following bear markets or recessions. This helps build wealth, as explained more below. Now that you’re seen why it’s crucial to have enough of your net worth allocated to cash, let’s get into the math.
The Equation for How Much of Your Net Worth Should Be in CashLet’s explore the equation in the beginning of this article into more detail so you can calculate how much of your net worth to keep in cash with more certainty.
Monthly Living Expenses X Number of Months = How Much of Net Worth Should Be in CashNow let’s get into some good ole personal finance. Boring? Perhaps. But I can almost promise you there will be at least one or two things you haven’t thought of in deciding how much net worth should be in cash so keep reading if you want to keep the lights on.
Part 1 – Monthly Living ExpensesThe first step is to get a very solid number for your monthly expenses. Here are some tips to fine-tune your monthly expense estimation. Remember, having this number wrong can destroy the best laid plan to not run out of cash.
Identify Where Money Flows OutKnowing your monthly living expenses used to be simple. For the most part, money was spent via checks and cash. Nowadays, money flows out from many places, including automatic bank transfers, bank checks, investment account checks, wire transfers, various online apps, and multiple credit cards. For example, recently I could only renew my library membership with a PayPal account. And I am setting up an app so my tenants can pay rent with it. Now my son wants me to set up another app for transferring money easier. The number of places money can flow out is endless, as you’ve probably noticed. Assuming all of this continues to be safe, the number of places money can leave your possession will only continue to multiply. If this all sounds very granular and unimportant in relation to your net worth, remember that knowing how much money you spend each month is 1 of the 2 factors in knowing how much of your net worth should be in cash so it’s important. I like to think of our monthly incoming cash as being in a bucket. And every place money flows out is a leak in that bucket. Consider all the holes in your bucket.
Total How Much Flowed Out of the BucketOnce a month total how much money flowed out through each hole in the bucket. Once a month is best to do this because you’re almost certain to catch expense mistakes before they happen again. If you can’t bear it, once a quarter is better than never, but you may miss important and big seasonal expenses. I keep bucket holes to a minimum so it’s easier to track our spending. I like to download, copy and paste expenses into one spreadsheet. Then I simply total all the expenses. You can set up an app for expense tracking or do what works for you. Whichever method you choose, make a note of the fixed expenses and the expenses that you can easily lower because you’ll need this later. This all sounds good, right? But it can lead to always feeling behind financially unless you take this next step.
Extraordinary expensesAt the bottom of my spreadsheet, I quickly note any occasional expenses that were seasonal or extraordinary expenses. These are usually big expenses like the ones below.
- Income taxes
- Holiday spending
- Legal or CPA fees
- Property taxes
- New car purchases
- Major home repairs
Part 2 – Decide How Many Months of Expenses to Keep in CashKnowing your expenses was about simply gathering data while knowing how many months to keep in cash requires some insight and evaluation. Most financial advice is to cover 6 months to 2 years living expenses, but you’re the one who will suffer if you’re wrong about the number of months to keep in cash. For more about managing your own money vs hiring a financial advisor read 5 Holistic Steps to Manage Wealth Sometimes the problem with financial advice is that it often varies greatly based on who you ask, and what they are selling. Six months is very different from 2 years, right? This means there is no set rule for everyone and only you can decide what’s best for you as leader of your wealth. Below are the factors to use for evaluating what percentage of net worth should be in cash.
10 Factors Affecting How Many Months of Net Worth Should Be in CashThere are many factors to consider in deciding how much of your net worth to keep in cash. Again, having too much of your net worth in cash can hurt your ability to build wealth and maximize investment opportunities. On the other hand, having too small a percentage of net worth in cash can lead to not being able to pay your bills in an emergency. So this step is super important to your overall net worth and financial security. But should you have six months or two years of living expenses in cash? Only you can decide but keep reading for more insights.
1. How Much Is Your Net Worth?Let’s face it. Someone with a net worth of $5,000,000 will probably need a smaller percentage of their net worth in cash than someone with a net worth of $500,000. This is because high net worth individuals have a bigger asset base to rely on when financial challenges surface. But the $5,000,000 net worth person may not have more in liquid assets, so keep reading. This is very important. Read my post on investment strategies a high net worth financial advisor uses to lower investment risk for his clients.
2. Liquid Net WorthThe amount of your net worth in liquid assets is a huge factor in determining your cash to net worth ratio. In this next step you’ll think about which assets in your net worth can be sold easily and quickly, and those assets that cannot. Assets that can be sold easily and quickly are liquid assets. The amount you have in liquid assets has a huge influence on how much net worth to keep in cash as you’re about to see.
Investment Real Estate as a Percentage of Net WorthImagine someone with $3,000,000 net worth. Sounds good, right? But what if almost all their net worth is invested in real estate? How will this affect the amount of net worth they should keep in cash? For one, real estate takes time to sell so if a crisis happens, they may not be able to access any cash by selling investments. And the economic factors that affect how easy it is to sell real estate are often also the cause of personal financial problems. This issue is what Dave Ramsey claims led to his own financial crisis. When the economy is struggling, the markets in which your assets are invested, such as real estate (or stocks), usually fall hard. Plus, real estate buyers tend to delay purchases when the economy tanks across the board for several reasons. This often leaves real estate investors with their net worth tied up in assets that are not only not liquid, but that cannot be sold, period. To add insult to injury, the investor’s overall net worth falls, too, due to the declining real estate (and other) investments. These high net worth investors can become real estate rich but very cash poor, especially with mortgaged properties.
Home Values and Net WorthThe same scenario can be applied to homeownership. It affects how much of your net worth should be in cash and many people don’t realize it during the good times. Imagine someone whose home has appreciated in value to $1,000,000. This can easily happen over a decade or two of living in one home. This situation would be similar to the real estate investor above, only worse because selling a home involves time to find a new home and to move. Buying a home almost always involves getting new financing. Plus, taxes could be due, depending on the amount of profit on the home. Not only this, but real estate sales are highly seasonal in most places. Putting your home on the market in August will get usually an entirely different result than putting your home on the market in April during the spring selling season. This seasonality may not coincide conveniently with your need for cash. All this to say having your home as a major portion of your net worth can lead to serious financial problems if you don’t have cash. Therefore, think in terms of liquid assets when deciding how much net worth to keep in cash. Read my post Is Downsizing Right for Me? Click the video below to see if downsizing is right for you.
Investment Portfolio Cash Is Very LiquidWhen compared to someone with a high percentage of net worth tied up in real estate, stock and bond investors will generally need a lower percentage of cash to net worth since they own very liquid assets. While a stock investor will experience nasty bear markets when they occasionally happen, most stocks can be sold in less than a minute, and you usually have access to your money within 3 days. Viola. Note that stock mutual funds usually sell at the end of the business day and take 1 to 3 days to get your money. ETF’s (Exchange Traded Funds) and individual stocks can be sold while the stock market is open but it takes 3 days to get your money. Bonds usually have the same access time when held in funds. In other words, net worth will decline for stock investors during bear markets, but the money invested in stocks is easily accessible. For this reason, it’s important to update your net worth often noting how liquid your net worth is at any given time. Note that while spending investment capital isn’t desirable, sometimes it needs to be done to pay the bills temporarily. Read my post entitled How Will a Stock Market Crash Affect You?
3. Cash Allocation in Portfolio Affects Cash to Net Worth RatioAfter you clarify how much of your net worth is in liquid assets (stocks and bonds) as explained above, next, see how much cash is in your investment portfolio since you’ll want to factor in portfolio cash when deciding how much of your net worth should be in cash. Most traditional investment portfolios have assets allocated (divided) among stocks, bonds and cash. But if, for example, you’re a proactive investor who has decided to increase cash due to an overvalued stock market, you may already be holding an unusually large amount of your investment capital in cash. Click here to read my post How to Understand Your Investments where I explain more about asset allocation in cash, stocks and bonds. Remember, the cash allocation in your portfolio is very related to the percentage of net worth to cash, but different since your net worth includes home equity and other assets. Think of them as one big financial picture since you can probably tap into your investment cash as a last resort should you need it for living expenses or financial emergencies. But also consider that some of your investment cash may be tied up in IRAs or retirement portfolios that cannot be used without a penalty of some sort. (You can borrow from IRA’s but check with your CPA since the rules change frequently.) This is another reason these two topics (net worth cash and portfolio cash) are related but also separate. It depends on your own situation.
4. Overlooked Liabilities Increase the Percent of Net Worth CashOne unforeseen liability can change everything. Make sure there are no overlooked liabilities that would increase the need to keep a higher amount of net worth in cash. Tax liabilities, lawsuits, and cyber security risk are all realities of life. Fortunately, measures can be taken to limit such unexpected liabilities such as good accounting, safe computer use, and various insurance policies.
5. Health Issues Increase the Amount of Net Worth to Keep in CashWhile many health problems can’t be anticipated, some can. Consider if you have potential health issues that could lead to you being unemployed or incurring expensive health care costs that aren’t covered by insurance. If so, you’ll want to adjust the amount of net worth you keep in cash accordingly so you’re not forced to liquidate an investment to cover medical expenses.
6. Amount of Fixed Expenses Vs Variable ExpensesYou distinguished between fixed vs variable expenses earlier. Some of your expenses could be cut quickly and easily if needed, such as shopping sprees for things you don’t really need and dining out. On the other hand, fixed expenses like the mortgage, utilities, and insurance don’t have much wriggle room without making bigger lifestyle changes. Identify your fixed expenses and total them. The more fixed expenses you have, the higher your cash as a percent of net worth will need to be.
7. Dependents Increase the Cash Net Worth AllocationYoung or adult children that are in a financial bind, aging parents, or other dependents increase the amount of net worth you’ll want in cash. This topic is a big conversation beyond this post. It’s a factor that many investors over 50 are experiencing in their retirement planning, sometimes at both ends, with both parents and young adult children needing financial help just to live.
8. More Income Earners Lowers the Needed Level of CashThe risk from potential job loss is lowered by having more than one income earner in your home. Therefore, for every additional income earner, you should need less of your net worth in cash. Another way to lower the risk from job loss is for either you or another income contributor to have highly marketable skills that can be used to increase income immediately if needed. Examples include social media marketing, content marketing, video creation or editing, graphic design, and consulting, to name only a few. Read 115 Businesses to Start Later in Life to get some great ideas.
9. Income Streams Can Lower the Percentage of Net Worth in CashThe more sustainable income streams you have, the less the percentage of net worth you’ll need in cash since you’re more likely to be able to cover living expenses from diversified income sources. Here are some examples of such income streams.
Investment IncomeIn your cash to net worth income evaluation, consider passive income from investments, such as dividends and interest. Note that unless you’re in retirement, you’re probably reinvesting investment income as an important part of your wealth building. In this case, however, when you’re evaluating how much of your net worth to keep in cash, you may decide to temporarily tap into investment income as a solution should the need arise. In other words, it’s there if you must use it but better if you don’t unless you’re reached your financial independence number. Read my related post How to Get More Income from Your Investments
Alternative Income StreamsOr you may have alternative income streams, such as real estate rentals, Airbnb, or small business income.
Online Business IncomeOnline income is becoming a staple income source for more people every day with the ease of creating websites and the multitude of ways to drive traffic to them from both ads and social media. Read my related post Starting an Online Business After 50 Read about the different types of online businesses and if it’s too late to start an online business. I include the importance of alternative income streams is as I have learned firsthand that it works. We have completely replaced job income with alternative income streams over the past 15 years after stumbling upon early retirement.
10. Debt Affects How Much of Net Worth to Have in CashThe amount of debt you have will affect how much of your net worth should be in cash for several reasons. First I’ll claim that I do think there is good debt and bad debt. But in general, the more debt you have, the more net worth you’ll want in cash for several reasons. First, if you get in a pinch, you can borrow money until you’re back on solid financial ground. If you already have high levels of debt, it will be harder for you to borrow money should the need arise. Second, the more debt you have, the more fixed expenses you’ll have. Third, if you have consumer debt, you’ll be spending more every month on, basically, nothing. While real estate debt could be helping you purchase an asset with the potential to increase in value over time, or even generate income, consumer debt has a zero chance of a potentially positive outcome.
The Bottom Line for How Much Net Worth Should Be in CashAs you can see, there are many factors affecting how much net worth to keep in cash or money market. Hopefully, I’ve touched on a few you may have not considered. The bottom line is that the amount of your net worth that should be in cash is the amount you’ll need to feel financially secure while allowing you to maximize wealth building.
The information on this website is for education only and is not to be construed as personal financial advice.