Well, there are a lot of people leaving $100 bills behind - a lot of $100 bills. I know because I look at their statements. This is especially on my mind now because I recently sat down with a lady in her mid-40s who had a bit more than $150,000 in various savings accounts and another $100,000 in certificates of deposit (CDs). The savings account paid less than 0.5% and the CD rates were between 1% and 1.25%.
Me: "You have a lot invested in cash equivalents."
Her: "In case of emergency."
Whoa...she's braced for a heck of an emergency.
Like most advisors, an emergency fund is one of the first things I talk about and make sure a client has in place - they are tricky. They depend on the stability of the client's income, type of car and age of house, etc. Basically you want to be able to pay your Discover bill at the end of the month after having to buy a new water heater. Assuming your job is stable, a couple of months' salary is sufficient.
As you have guessed, having too big of an emergency fund leaves $100 bills on the table. This jumps out at anyone who is aware of yields available in the market place. If you have $50,000 more in emergency funds than you need and can increase the return on these funds by 2%/year, it amounts to $1,000/year. Where's Chauncey?
Do the math for the lady in the example who has $250,000 in cash equivalents! Because she is in her mid-40s, she has approximately 20 years until she is 65 years old and will compound the money over the period. She is leaving a lot of $100 bills on the table!
On occasion, the dialogue has gone like this:
Me: "You have a lot invested in cash equivalents".
Her/Him: "Stocks and bonds are risky."
Let's talk about risk.
Stocks and bonds do go up and down, and that can be truly exhilarating or lead to grinding your teeth in your sleep depending on the extent to which you watch it and let it affect your emotions. That's the risk most people focus on. But there is also inflation risk that is more subtle. For example, it seems like yesterday when people would tell me that they could invest in U.S. Treasury notes and generate $40,000/year. Why did they need stocks or higher yielding, more risky, fixed income exposure? Fast forward to today, and $40,000 is equivalent to $20,000 and their 10-year Treasury note re-investments yield 1.6%!
Yesterday the 12-month Consumer Price Index was reported at 1.7%. Investing cash equivalents at less than 0.5% or even in CDs at 1.5% is losing ground to inflation! The bottom line is that risk comes from many directions, and hiding in cash equivalents leaves a lot on the table. It pays to investigate low risk ways of increasing yield on emergency funds and other short term investments..
Disclosure: The purpose of this post is educational. Individuals should consult with a professional or do their own research before making investment decisions.
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