Cash flow is one of the first topics I like to cover when working with new financial planning clients. Cash flow is so fundamental to the rest of your household finances that it’s really helpful to understand how much money is coming in every month and how much is going out. With this in place we can begin to wrap our heads around concepts like your capacity to take risk, disability insurance needs, and other components of a typical financial plan.
We can also use this information to determine how big your cash reserve should be. There are many different names for a cash reserve: cash buffer, cash safety net, emergency fund, and so on. Regardless of what you might call it, the objective is to keep enough cash on hand so that no matter what happens in your life, you don’t need to sell investments at an inconvenient time (i.e. during corrections or market crashes).
The easiest way to view your cash reserve is as a function of monthly living expenses. Simply multiply your monthly living expenses by the number of months you feel comfortable with and voila! That’s how big your cash reserve should be.
During your “accumulation” or working years, most financial planners recommend a cash reserve of somewhere between 6 and 24 months’ worth of living expenses. Where you fall on that spectrum depends on a several different factors:
- Your capacity and willingness to take risk
- How many incomes you have in your household
- How consistent your income is
- How many dependents rely on your income
- What your disability insurance situation looks like
In retirement the situation is quite a bit different. You’ve already amassed the amount you need to quit working, and are obviously not concerned with the possibility of being laid off. Instead, the biggest issue is avoiding having to sell assets at an inconvenient time.
It’s a challenging line to walk. You want to keep enough cash on hand to cover unexpected expenses and avoid selling stocks in periods of market turmoil. But you also don’t want to keep more in cash than you need to. Keeping too much is a drag on your portfolio, and inflation will slowly eat it away over time. The right amount of cash for you in retirement depends on a different set of factors, which I’ll cover in this post.