People go through different stages in their financial lives, hopefully improving as time goes on. At some point you will likely reach a stage that can be called Accumulation Phase, or Phase 3 in this good article from Moolanomy about financial health. In summary, you are no longer spending more each month; that is, you have enough money to pay your bills with some money leftover for savings and investment.
I think that this is the most difficult step to tackle. You might not know what to do next with the money you are saving. From my own experience, I’ve never had problems with debt but I have stumbled investing, it took a while to learn enough about it to make intelligent decisions. I’m still learning.
This post is not about what you should do specifically with your savings, but I talk about 4 concepts that are important to understand about how to manage your stash. Even if you do invest your cash later on, you very likely will still maintain some level of cash reserves. Here’s some things you need to know.
1) Maintain Liquidity
If you read personal finance articles a lot, very common advice given is to keep 3-6 months in emergency savings to handle unexpected bills, unemployment, etc. This advice is good, it’s an example of liquidity. This simply means the ability to get access to cash quickly with limited or no loss of principal. A savings account at a bank is very liquid, you can withdraw cash in minutes at an ATM or a cashier. Your home is not liquid, it takes weeks or months to convert to cash; though, it could happen quicker if you are willing to sacrifice principal (sell it at below market value). Another example – cashing in a 6 month Certificate of Deposit (CD) early will usually result in a loss of earned interest.
So, cash is good because it enables you to plan for future expenses as well as handle any unexpected ones (new water heater, e.g.). After all you want to be able to pay for expenses without credit card or other debt if possible. Here are some examples of places to put your money that have high liquidity:
- Savings/Checking Accounts
- Money Market Accounts
- Short Term U.S. Treasury Notes
2) Inflation Effects
In this article I talk about what cash is and why it’s not a good investment. Cash is good for the short term, but over the long term it loses value due to inflation. Inflation is caused by the general increase in money supply as well as the rising prices of goods and services over time.
Here’s an example of inflation:
As an avid coffee drinker over the years, I can recall how much coffee has increased in price over the years. In 1998, I could buy a large cup of coffee for about $1.25, today the same cup costs $2.20. That’s an increase of over 75%. If you saved money in a cash savings or money market account over the 12 years, you very likely would be able to buy the same cup of coffee today, and no more. You didn’t gain an additional return by saving, however, this is still way better than saving nothing.
Short of putting cash under your mattress, there is some level of risk of loss wherever you choose to put your cash. But, typical places that people put their money can be virtually risk free, while others can be just a bit more risky. During the 2008 Credit Crisis, it became very clear about what things are safe and what are not. Here’s an example of a product marketed as ‘safe and liquid, equivalent to cash’, but during the crisis was neither: auction rate securities.
When viewing risk, also add in liquidity into the equation. On paper, the FDIC/NCUA (the federal agencies that insures bank/credit union deposits) guarantees your deposits, and I don’t question it. However, if your bank fails, what is the process and how long will it take to get your money back? After all, if you need the money quickly and can’t get it, that’s almost equivalent to losing it.
Here are some places to put your cash and their risk level:
- U.S Treasury Notes – virtually risk free, very high liquidity. Backed by the U.S Government.
- Savings/Checking Deposits – very low risk, high liquidity. Risk of liquidity loss due to bank failure. FDIC/NCUA insured.
- Money Market Accounts – very low risk, good liquidity. FDIC/NCUA insured. Risk of liquidity loss due to bank failure.
- Money Market Funds – low risk, good liquidity. NOT FDIC/NCUA insured. Principal loss is unlikely but possible.
- Certificate of Deposit (CD) – very low risk, low liquidity. FDIC/NCUA insured.
4) Return On Investment
Cash investments don’t typically earn as much money or interest as other fancier options out there (particularly over the long term), such as stocks, bonds, and other investments. But, this doesn’t mean that you should ignore returns because doing a little bit of moving around can significantly increase the interest you earn on your cash. Here’s what affects your return on cash:
- Liquidity – lower liquidity (6 month CD versus checking account) will increase your return.
- FDIC/NCUA insurance – Accounts with these government insurance policies will earn lower returns than accounts that do not offer insurance – e.g., money market funds, municipal bonds.
- Service Level – Accounts that offer fewer services/limited access have higher interest rates. For example, money market accounts have a Federal restriction which prevents more than 6 transactions per month.
The easiest way to earn more money with your cash is to go to your bank/credit union and ask about opening accounts that earn more interest. These accounts are typically money market accounts or Certificates of Deposit (CD).