Cash Reserves

For this, you should listen to your parents.

You have probably heard that building up an adequate cash reserve is a wise move. You’ve probably heard this advice from a parent, or even a grandparent, and there is a good reason why.

What is Cash Reserves and where does it fit into your overall portfolio?

I prefer to not think of cash reserves as a part of my investments. Investing in a mutual fund or a 401(k) plan, for example, involves a longer time frame. I invest in a 401(k) plan for the long-term and for building up a retirement nest-egg when that day finally arrives. I use mutual funds for shorter-term investment goals such as buying a house, or even a new car. The time frame is what is important as the longer I hold the investment, generally, the more I can expect a reasonable rate of return.

Cash Reserves are not for a financial goal either in the short-term or the long-term.

These reserves are for much more important needs that may or may not appear in my life, and yours. Theoretically, cash reserves have one important function. They are funds you have set aside that are both available to use at a moment’s notice and can replace your income in the event that an unexpected expense appears.

You may have even experienced various types of unexpected expenses already. For example, you get into an automobile accident. There may be expenses such as your need for a rental car because you must go to work while your car is being repaired. There are also smaller, unexpected expenses such as the water heater, or refrigerator, in your home decides to stop working. You need to replace or repair it and the expense will be paid from what you have available. If you budget your income (and you should), then any expense that you did not plan for will destroy your budget and your plans.

There is an easy way to determine how much in cash reserves is adequate.

Many financial professionals have a theoretical amount that they believe will cover any reasonably imagined unexpected expense. I have heard of 3 months’ worth of your expenses. I have also heard of 6 months’ worth of your expenses.

The theory is based on one unexpected expense, and the largest, that many people fail to plan for, either out of neglect or denial.

The biggest unexpected expense is if you loose your job and can’t pay any expenses.

If you lost your job today, how long would it really take to find another job that paid as well or better than the one you are in right now. Would it take 3 months? Would it take 6 months? This is something that you need to determine for yourself. It may only be a couple of weeks, you believe, but if you are in a professional career, it may take longer and you may have to move to take the job.

How long would it take to replace your income, if you had to find a new job and that job was in a different city? It would take more than a couple of weeks. In fact, it may even take more than 3 months.

No matter how long it takes, you believe, add one month to your expectation just to be safe.

The best place to put your cash reserves.

These reserve funds need to be:

• In a place that you can get to right away.
• They need to stable and not become less than your need, when you need it.
• They need to be equal ot the number of months it would take to replace your income.
  

The best place to put at least one months’ worth of your expenses is into a savings account. Why? Because you may need to access some money right away. By “right away,” I mean today. If you need a tire replaced on your car, you will need enough to pay for it within a couple of hours. If your water heater needs replacing, you will need to pay for a new one today.

Cash Reserves need to be separated into two areas: Depending on when you need them.

The second place you can put cash reserves is into a stable investment that you can access within 7-10 days. Since you have your expenses covered for the next 30 days in your savings account, you can wait a week or so before getting access to the remainder of the reserves.

A good place to put this second tier of reserves is into a municipal bond fund or a dividend stock fund. The value of the shares are stable and don’t move up or down very much. You can expect to get back what you put in at the very least.

Municipal bond funds are a neglected investment choice.

Putting two months, or more, of your expenses into either of these types of mutual funds creates an interesting benefit. The municipal bond funds are expected to return 2-4%. The earning you receive, however, are not taxed by the federal government. If the municipal bonds in this fund are from a state or municipal governement where you live, you may be able to avoid taxes on the earnings as well.

Dividend stock funds are an easy way to take advantage of a lucrative and stable investment.

If you choose to use a dividend stock fund, you will not be able to avoid taxes on the earning. However, the price of these stocks are relatively stable and the dividends that are returned to the investor every quarter, are taxed as ordinary income. These types of stock investment (bought through a diversified mutual fund) produce an expected rate of return of 3-5%, depending on the dividends those companies pay to investors.

In either choice, municipal bonds or dividend stocks, the expected rate of return is higher than what you can expect from a savings account. In fact, you can expect the return to be on par with the normal rate of inflation - i.e. you money does not shrink due to the rise in consumer prices.

Here are 5 great ways to build cash reserves.

1. Spend less than you make. This is old sage wisdom and if you are serious about building wealth in the years to come, you will take this wisdom and follow it. This is the only way you will have money in the years to come for investment, vacations, or even buying a house.
2. Create a side hustle for yourself. Effectively, you are increasing your income without increasing your expenses. This creates more excess income that can be used to build your cash reserves. Once the reserves are created, you can stop pursuing the side hustle.
3. Sell Stuff. If you are like nearly everyone, you have things that you just don’t use anymore. Power tools, or furniture, or something that once had value to you but doesn’t anymore.
4. Liquidate a small portion of your investments. This is a somewhat radical approach. You could liquidate your current investments - if you have any - and achieve the goal of creating an adequate level of cash reserves right away. With this strategy you can build up your investments with excess income while you are protected from unexpected expenses.
5. This last method may not be available to you. It involves borrowing the amount you need from a family member who will not charge interest. If you can get a firm idea on the strategy of building cash reserves - the why, how, and what - you may have a family member who will support you, lend you the money, and take a payment from you eac month.

This last strategy has one benefit not available in the other 3. If you can arrange this, then you have created your cash reserves all at once. You can spend the next year or so paying back the family member, but from this moment forward, you have the protection of having adequate cash reserves.

One final word on Cash Reserves.

There are many people out there claiming to be financial experts. All of them, in an effort to distinguish themselves and get noticed, come up with all sorts of financial and investment strategies - including strategies about building cash reserves. Some of these strategies work and some are simply reworded versions.

Make up your own mind about what you should do based on simple approaches to the problem. If you agree that you need to build cash reserves, then work out the best way to go about it from the 5 ways above. If you agree with my recommendation for where you should keep these funds, then setting it up at any well known brokerage firm, or even something as simple as Robinhood investments, will do just fine.

The best advice anyone can give for personal finance issues and plans is to make up your own mind after you have learned how the investment works, and how to access it.

Now. It is time for you to start making up your own mind. What is your first step?

Thank you for reading,

George M Potter

. . .

George M Potter is a retired Financial Advisor who enjoys helping people sort out their personal finances. He writes weekly on topics of Personal Finance on his blog Signalfinance.org (a substack blog). His blog can be reached at https://signalfinance.substack.com.

Disclosure Statement: The content you receive from Signal Finance is for informational purposes only. This content should not be considered financial advice in any way. If you choose to use the information then you do so of your own accord and Signal Finance cannot be held responsible in any way. By reading the content you receive from Signal Finance, you agree to these terms and conditions.

If anyone wants to reach out please Contact Me!

As an Amazon Associate, I earn from qualifying purchases and I earn from links but not all

This article is informational; it should not be considered Health, Financial, or Legal Advice. Not all information will be accurate. Consult health, financial, or legal professional before making any significant decisions

Follow me on Twitter!

Books, Credit Cards, Software and Products I recommend