Cash: What counts as cash, purpose of cash, risks, and guidance
Definition of Cash
Liquid funds that are available for covering expenses. This could include, but is not limited to, the following:
Checking, savings, CDs, or money market accounts at a local or online bank
Brokerage Cash Sweep
Brokerage money market funds (including municipal funds)
Ultra short-term or short-term bond ETFs or mutual funds
Brokered CDs
Treasury Direct IBonds
Cash value life insurance, excluding variable life (if already existing)
Purpose Cash Serves in a Financial Plan
There are three purposes for cash in a financial plan:
Operating cash to cover your next 1-2 months of expenses
Emergency reserves to cover 3-6 months of expenses
Cash needed for expenses not covered by income streams (property taxes, car purchase, home purchase, remodel, etc.) in the next 0-2 years.
Risks
Holding cash introduces the following risks:
Institutional - bank failure or brokerage failure (addressed with careful selection of institutions and backed up by FDIC or SIPC protection).
Inflation risk - risk that inflation will erode the real value of your money over time. If the rate of inflation is higher than the interest you earn on your cash, your purchasing power diminishes
Reinvestment risk - Interest rates can fluctuate. If you hold cash (or short-term instruments like CDs) and rates drop, you may be forced to reinvest your money at a lower yield, reducing your future income potential.
Opportunity cost - Cash typically offers much lower returns compared to diversified investments like stocks and bonds over the long term. By keeping too much money in cash, you miss out on the potential for wealth accumulation through investment growth and compounding, which is essential for achieving long-term goals like retirement.
Guidance
Cash is an asset class but is not an investment, as expected returns over time will lag those of stock and bond investments. However, cash is necessary in a plan to ensure your ability to cover expenses without relying on credit. Your cash balance should be the minimum amount needed to fulfill the three purposes of cash in a financial plan, and any additional cash should be invested to serve longer term goals.
