Dave Sather's Money Matters: The cost of cash
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By Dave SatherThere are many "rules of thumb" that address how much cash an individual needs in the event of an emergency. Often, we are told the minimum should equal three to six months of living expenses. Although that is a good number, we have seen an obsession from clients wanting too much cash. Yes, too much cash.
Although this is an odd statement, there is such a thing - and we are seeing it more frequently. Much of the desire to have high cash balances stems from the pain felt during the 2009 economic downturn, when the stock market sold off by more than 50 percent. It was painful indeed. However, too much cash can be just as bad as too little cash.
We recently had this discussion with "Marcy and Clay." As they struggled with how much cash to keep on hand, we asked them a few questions to focus on the consequences of holding cash and how much may be needed.
First, we discussed what cash actually gets us. Although the answer may be obvious, investors must recognize that cash is not a "store of wealth" but rather a tool that allows us to conduct commerce. Cash allows us to buy groceries - but it will not go up in value or grow due to its productivity.
Conversely, cash actually erodes over time. As I made this statement, Marcy asked me what I meant. The erosion of cash's purchasing power comes mainly at the hand of inflation. Over very long periods of time, inflation has averaged about 3.5 percent per year. Although this is an interesting tidbit of trivia, I was not making my point.
As such, I attempted a different perspective. I told the recent retirees to assume they have $100,000 in cash today and we experience 3.5 percent inflation per year over the next 20 years. The negative impact of inflation means that 20 years from now their $100,000 will only purchase $49,000 worth of groceries, gas, health care or other items. If inflation runs at 5 percent over 20 years, purchasing power is reduced by 64 percent to a slim $36,000.
Marcy's eyes got big as the long-term impact became obvious. Understandably, she wrestled with the volatility of the stock market as well as the guarantee of lost purchasing power on cash.
To help them work through the dynamics of assessing "how much cash is needed in an emergency" I asked Marcy and Clay to assume that in one day their house burned down, both of their cars were stolen and then they went into the hospital, maxing out their deductibles. The mental gymnastics did not require precision but rather a rounding up of the funds a couple might need if all of these things happened at once - and they had decent insurance.
Although their homeowner's deductible was $3,000, we rounded up to $10,000 to cover several months of apartment rent. We added another $5,000 for clothes and food. The deductibles on their cars would be another $2,000, but we rounded that up to $10,000 to cover depreciation. Finally, we tackled the cost of health care and decided that $50,000 would buy them a tremendous amount of coverage. No matter the perspective, I could not come up with a plausible situation in which Marcy and Clay needed immediate access to more than $75,000 of emergency money.
Clay grinned as he got my point. Marcy wanted another option that did not exist. Unfortunately, in a "zero interest rate world" there are few options that will preserve the purchasing power of emergency money - that do not encounter principal volatility or require long time frames and considerable patience.
As we finished, we reviewed the issues again.
First, weighing a large portion of your assets too conservatively or too aggressively can have catastrophic consequences. Secondly, even though the financial markets have been volatile, holding cash for long periods of time will guarantee losses in purchasing power. Given this, smart investors must determine the right mix of highly liquid assets that can be used immediately against long-term assets that have the ability to build wealth and outpace taxes and inflation while tolerating bumps in the road.
Dave Sather is a Victoria certified financial planner and owner of Sather Financial Group. His column, Money Matters, publishes every other Wednesday.