Question: How much cash should I have on hand?
We're looking for the Goldilocks approach here — not too hot (too much cash) or too cold (too little cash). But just the right amount.
Of course, your version of “just right” is entirely dependent on your situation.
So to help you figure out what enough looks like for you — you can start by considering two perspectives:
- the numbers perspective (quantitative) and
- the emotional perspective (qualitative).
First up, let’s talk numbers:
You’ve likely heard the rule-of-thumb that you need 3-6 months of expenses in cash (you could do a lot worse than this!) And I think it's a great place to start if you want a quick and dirty framework to implement.
A few things to consider for the 3-6 month spectrum:
- The more variable your income, the more cash you want.
- The more fixed your expenses, the more cash you want.
- If you have some high-interest debt (e.g., credit card), have less cash and pay down those credit cards.
- The higher your prospects are of being able to increase your income, the less cash you need.
Unfortunately, most people stop at numbers. But I think there is one additional step that is crucial.
You have to ask yourself how much cash on hand would help you sleep better at night.
Personal finance is more about emotions than numbers and you have to (1) understand how money affects you and (2) take those emotions into consideration when making decisions.
Let's say you did the 3-6 month math and came up with a number of $15,000 to $25,000, but for whatever reason, you had $40,000 in your mind as the sleep-well-at-night-number.
In that case, I recommend you set your cash goal for $40,000.
Is there an opportunity cost to keeping that amount of cash on hand? Absolutely. There are always trade-offs. But at the end of the day, you are trading lower anxiety for lower potential financial gains.
Would higher financial gains be better? Sure they would, but they aren't guaranteed and they probably aren't going to make a material difference in your financial future.
The long-term is nothing more than a series of short-terms. And if having more cash on hand allows you to endure the vicissitudes of the short-term — in order to accomplish your long-term goals — it's worth having more cash on hand for more peace of mind.
So, start with the 3-6 month measure as your baseline and commit to having no less than three months of cash. Then overlay the qualitative (your “what lets you sleep at night” number) and, if it results in a number that is higher than your baseline — go with that!