Take it away, VagabondMD!
Top 5 Reasons I Keep a Half Million Dollars Under My Mattress*
(* my wife asked me to add here that we really do not keep any money under the mattress. None at all. Really.)
It is personal finance dogma to maintain a liquid (i.e. cash) emergency fund which would be expected to cover three to six months of living expenses in the event of job loss, illness, or other personal or financial catastrophe.
While this is considered by many to be the first thing that you do in your financial plan, before contributing to 401(k) accounts or 529 plans, many are woefully unprepared for what life throws at us on a fairly regular basis . A well-publicized 2016 survey revealed that the majority of people could not manage a $500 surprise car repair without going into debt, let alone being let go from work.
On the other hand, there are many in the personal finance blogosphere who scoff at the idea of a 3-6 month cash cushion. There are other alternatives to resorting to idle cash, including tapping your home equity line of credit, selling investments from a taxable account, and invading the Roth IRA.
Why leave three to six months of expenses, thousands of dollars, in a lowly savings account (currently yielding 1% or less) when you can have the money at work in the stock market, in real estate, in your business, or somewhere else (anywhere else) where the expected returns are much greater? I am going to tell you why.
But first, i would like to dispel some of the hyperbole in the title. My current cash cushion is not $500,000, but, as I demonstrated to my wife last week, it is $475,000, which I would expect to cover 5 years of living expenses in the event of a sudden, unexpected dual job loss. Second, not all of the money is in savings account or in one bank, but it is distributed in two online banks, one local bank, and two brokerage accounts, in checking, savings, and money market accounts and in CDs. (If you add in the very liquid savings bond position, the total would be north of the $500k.)
On to the reasoning…
1. Recessions happen
We have lived through two major recessions in our professional lives, 2000-2002 and 2007-2008. In both cases, we had countless friends in “good, stable jobs” that lost these “good, stable jobs” and witnessed the financial and personal carnage that this wrought upon them.
Or my IT friend, an executive in an international financial firm who was forced to train Indian software engineers to replace him as his US-based job was eliminated and moved abroad after the tech meltdown. Neither of these guys saw it coming. I do not see it coming either, and I do not generally do well with carnage— it’s not in my DNA.
2. Fear of Locking in Losses
It is very likely that when there is another financial upheaval, some of the other assets that you own will lose their value and or their liquidity. It happened in the early 00’s and again in the late 00’s.
Do you really want to be forced to tap your Roth IRA when the S&P 500 fund in it is down 50%? Or sell your house or investment property when no one can get a mortgage loan to buy it? Both are great ways to lock in a loss.
3. Why Play a Game You’ve Already Won?
William Bernstein, the esteemed neurologist and author, said in his book, The Ages of the Investor: A Critical Look at Life-cycle Investing, “When you’ve won the game, why keep playing it?”
The gist is that if you have enough saved to live in retirement, reduce the risk you take with your portfolio, especially later in life and as you approach retirement. In personal finance parlances we often talk about “The Number”—how much of a nest egg you need to call it quits on the day job.
Is it a big number pulled from the sky like $1 Million, $5 million, $10 million or $100 million? Is it a multiple of annual living expenses like 25x in the Trinity study or a more conservative and ambitious 33x? “The Number” is a rather elusive concept, but even while we are working, we are presently a bit north of our Number, by about, say, $500,000. Having a large cash position pays homage to Dr. Bernstein’s concept by taking some chips off the table.
4. Interest Rates Are on the Rise
Interest rates are likely rising in the next few years, after a prolonged period at historic lows. Janet Yellin largely promised this in December. As interest rates go up, the value of your bond holdings will decrease. In this environment, is it really crazy to have a chunk of your fixed income allocation where there is no interest rate risk, in a savings account?
5. Following a Three Bucket Strategy
My wife and I are in our early 50’s, working full time in demanding medical and legal positions. I plan to cut back to part time later this year, and we both expect to be retired from our current professional jobs in three years. The $500,000 cash position transitions nicely to the cash bucket of a Three Bucket Strategy.
If our equity investments continue to increase in value in the next few years, we are on track. If the stock market takes a dive between now and then, we are still on track. Either way, we hope to spend our retirement alternatively working as tour guides in Florence, Italy and Yellowstone National Park.
Cash is Not Trash!
In fact, cash is still accepted in many places for good and services. In one’s personal finance portfolio, I prefer not to think of it as an anchor holding back returns but the lifeboat that might save you when the boat hits the iceberg. Or maybe the dinghy that takes you ashore when you are tired of sailing.
It is flexible, it gives you options, and it is there when you need it. Earlier in my career, even when my human capital was near its peak, I preferred to have an out-sized cash position and over time, with more life experience and a professional career in the bottom of the eighth inning, I value it even more.
[PoF: Today’s guest post is a good example of personal finance being personal. I wouldn’t choose to hold so much cash, citing math as the principal reason. VagabondMD has his reasons, which are largely based on risk tolerance and the ability to sleep well at night.
There is no right answer, but each of us can have a best answer as it applies to our personal situation.
The question of bonds and rising interest rates is an interesting one. The resale value of an individual bond will fall when the interest rate rises, but what happens to bond funds isn’t entirely predictable. When some bonds reach maturity, they are replaced with new bonds at the new, higher interest rate. If you’re interested, Schwab has explored a number of periods of rising interest rates and the effects on various bond funds. Hint: we should be OK.
Personally, I keep a miniscule cash cushion of one to three months’ expenses, or less than 4% of VagabondMD’s $500,000. I like to put my money to work, but that’s just me.]
To read more from the prolific guest author, Vagabond MD, see all of his articles:
What do you do? Would a large cash position make you feel better or worse about your future prospects? Will you continue to play the game after you’ve already won?