Today’s year-end planning tip is to Reassess your cash position.
The question of the hour is where to keep your cash as yields drop well below the 5% that investors enjoyed throughout most of 2024.
Let me run through a quick framework to help determine where to best allocate your cash:
First, What is the purpose of the cash? Maintaining a sufficient level of cash helps families pay their routine bills and provides a cushion in case of an emergency. This is typically 3-6 months’ worth of expense money. It’s also important to have enough cash for any short-term large financial outlays. Anything more than that may be financially imprudent.
Next, let’s discuss the fallacy of “risking principle”: This phrase drives me absolutely crazy! Oftentimes, friends will tell me that they like to keep their funds in cash equivalents so they “don’t risk losing their principle.” This shows a lack of understanding of risk and how it impacts our lives. Remember, money that is kept in cash for too long will inevitably end up LOSING buying power in the future.
While the dollar amount appears to slowly increase every year, it is not rising as quickly as “inflation.” Therefore, if you intend on saving money for your future, keeping it in cash or bonds, which will UNDERPERFORM the rate of inflation, will ensure that you can buy LESS goods and services with your dollars.
Next consideration is your time horizon: Ultimately, when you will need your money should determine where to put it. For example:
Cash equivalents: Should typically only be used for an emergency fund of 3-6 months’ worth of expenses, or possibly a bit longer if you have a significant upcoming expense. Suitable cash investments for this bucket are money market funds, CDs, and perhaps T-bills. Even as rates continue to drop, you don’t want to risk short-term funds in other investments. The key is having LIQUIDITY when you need it.
Next are Bonds: which typically offer lower returns than stocks, but higher returns than cash equivalents. Bonds are useful in achieving intermediate goals since they help diversify a portfolio and reduce investment risk. If you have a goal that is less than 10 years down the road, bonds should be a component of your investment strategy.
And finally, there are Stocks: which are the ultimate investment for long-term portfolio growth. If you’d like your portfolio to grow over the long-term and outpace inflation, stocks should be a significant portion of your holdings. Any investor with a 10-year or longer time horizon is doing themselves a major disservice if they don’t own enough stocks.
There are also alternative investments, which most people should avoid. They are typically less liquid, far more expensive, tax inefficient, and usually don’t achieve the returns they claim. They are also mostly sold on hype and not on their merit.
Here’s a Planning Tip: which is asking yourself: “What are you looking to accomplish with your money?” Your answer will determine when you need the money and lead you to the correct decision based on the framework I just laid out.