Let's talk about cash.
It might not be the most exciting part of your portfolio, but it's absolutely essential. I often find that people either hold too much cash or not nearly enough. Here are four essential rules for effective cash management, from building the right emergency fund to knowing where to park your money and when to invest excess cash.
The foundation of smart cash management is an emergency fund. This should cover your essential living expenses, such as housing, food, and utilities, for three to six months. An emergency fund provides a buffer against unexpected events like job loss, medical emergencies, or major home repairs.
It's important to tailor this amount to your personal circumstances. If you have a very stable job and multiple income streams, perhaps three months is sufficient. If your income is more volatile, you're self-employed, or you are the sole breadwinner, you might want to lean toward six months or longer.
Your cash reserves should also account for short-term financial goals --anything you plan to spend money on in the next one to two years. This could include things like a down payment on a car, a home renovation project, or an upcoming vacation.
Holding excessive cash can be a drag on your overall investment returns. While cash provides stability and liquidity, it typically earns very little, especially in periods of low interest rates. Inflation also erodes the purchasing power of cash over time.
Once you've satisfied your emergency fund and short-term goals, any cash beyond that should be invested in a portfolio structured according to your personal risk tolerance and long-term financial plan. The key is to strike a balance. You want enough cash to meet your immediate needs and provide peace of mind, but you don't want so much that it hinders your ability to grow your wealth over the long term.
Where you hold your cash is also important. For most people, a combination of savings accounts and money market funds is appropriate.
High-yield savings accounts are great for accessibility and safety. They're FDIC-insured (up to $250,000 per depositor, per bank) and typically offer better returns than traditional savings accounts.
Money market funds are another strong option. These funds invest in short-term, high-quality debt and aim to maintain a stable value. They may offer slightly higher yields than savings accounts, especially during periods of rising interest rates. While they aren't FDIC-insured, they're generally considered low-risk.
In a high tax bracket? Consider municipal money market funds. They invest in short-term government debt, and their income is usually federal tax-exempt, giving them a higher after tax return.
Finally, it's crucial to be aware of insurance limits on your cash holdings. The FDIC insures deposits in banks up to $250,000 per depositor, per insured bank, for each account ownership category.
If you have cash holdings that exceed these limits, you may want to consider spreading your money across multiple banks to ensure full coverage. Alternatively, you could explore other options like brokered CDs, which can sometimes offer higher insurance limits.
While the risk of losing your cash in a bank failure is low, it's always prudent to be aware of these limits and take steps to protect your funds.
By following these four rules, you can ensure that you're managing your cash effectively, providing both financial security and the opportunity to grow your wealth over the long term.
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This article was provided to The Associated Press by Morningstar. For more personal finance content, go to https://www.morningstar.com/personal-finance
Sheryl Rowling is an editorial director at Morningstar.
