How much of your wealth do you hold in cash? And how much of your wealth should you hold in cash?
Two very important questions often with rather different answers. We will discuss the pros and cons of holding cash and what we consider is the sweet spot in how much you should hold in cash.
Whilst it’s often viewed as the ‘safe’ option, there are potential dangers in hold too much or not enough.
First, the risk of not enough cash. If you don’t hold sufficient cash, you can create cash flow stresses when unexpected expenses or emergencies arise. The amount you should hold is dependent on your specific circumstances. In general, and subject to your particular situation, less than 3 months of living expenses is generally not enough. At the other end of the scale, any more than 6 months’ worth of your cost of living expenses, or net income after tax is too much. There are obviously exceptions to this and some cases where it is prudent to hold even 12 months’ worth, however, the norm is 3 to 6 months. To be sure you are in an adequate and appropriate position, we recommend you arrange a meeting with us and we can analyse your position and suggest what is an appropriate level for you.
The dangers of too much cash
When markets are volatile, it is easy to see why people might choose to hold large sums in cash. As it’s something we handle every day, whether physically or digitally, it can seem more tangible than other assets. However, cash does lose value and this is particularly true in the current low-interest climate.
Interest rates have been at a historic low for more than a decade following the 2008 financial crisis. The European Central Bank official interest rate is actually negative 0.25%!
A low interest rate is good news for borrowers, but the low interest rate environment is not positive for savers. It means your savings likely will not deliver the returns they once did, especially if you compare the current rates to the pre-2008 rates of return on cash.
If you hold too much of your wealth in cash, you won’t be able to keep pace with inflation, meaning your purchasing power will go down and it will be more difficult for you to achieve your goals.
Inflation: Affecting the value of savings
The reason the value of cash savings falls in real terms is inflation. Each year the cost of living rises and if interest rates fail to keep pace with this, your savings are gradually able to purchase less and less.
The European Central bank and the EU countries’ governments aim to keep inflation between 2-3% and in recent times have kept it lower than that. However, with the increase of cash injected into markets to stimulate the economies of Europe in response to the coronavirus pandemic, there is a risk that inflation could increase in the short to medium term. If inflation goes up, your spending power goes down.
Year-to-year, the impact of inflation can seem relatively small. Yet, when you look at the impact over a longer period, it highlights the danger of holding too much in cash. If you hold excess cash in your bank account at say 0.1% pa interest and inflation is 2.5%, you are in fact losing 2.4% every year.
And if you look at inflation in terms of your long-term or retirement goals you can really see the impact. Here’s an example: if you are planning on retiring in 25 years and think you need €3,000 income per month in retirement, when you take inflation into account, you will actually need double that, €6,000 per month!
When is cash right?
Whilst inflation does affect the spending power of cash savings, there are times when it’s appropriate.
If you need ready access to savings cash accounts are often suitable, for example, as we mentioned above, having an emergency fund.
When you’re saving for short-term goals (those less than five years), a savings account should also be considered. Over short saving periods, inflation won’t have as much of an impact and can preserve your wealth for when you need it.
However, when setting money aside for long-term goals, investing in diversified growth focused assets aligned to your goals, your risk profile and other impacting factors may be a better option that’s worth considering.
Investing: When should it be considered?
Investing savings means you have an opportunity to beat the pace of inflation with returns over the long term, thereby, preserving or increasing your spending power.
However, investment returns can’t be guaranteed and short-term volatility can reduce values, as recent markets have demonstrated. For this reason, investing as an alternative to cash should only be considered if your goals are more than five years away. This provides an opportunity for investments to recover from potential dips in the market.
If you’d like to talk us about the balance of your assets, please contact us. Our goal is to align aspirations with financial decisions, helping you to strike the right balance.