Learn How Much Money to Keep In a Savings Account
Determining An Appropriate Level of Liquidity for Your Own Savings
One of the things I notice a lot with inexperienced investors is the disdain they seem to hold for keeping money in a savings account or, if higher net worth, parked directly in Treasury bills at the United States Treasury. This is a problem because you can't really begin a successful investing program until you have a good foundation under your financial feet.
A huge part of that foundation is your liquidity situation.
In accounting terms, liquidity refers to the resources on your balance sheet that is in, or can be easily, cheaply, and quickly converted into, cash. The highest priority for liquid assets are that they are going to be there when you reach for them, and safety of principal is never at risk.
It's no secret that, for the small investor, the most popular way to park money aside for liquidity purposes is to use a savings account. We've talked about savings accounts in the past few days, including an article I wrote called 5 Things You Should Look For In a Savings Account, that detailed a list of the features or behaviors you should demand from your bank or financial institution.
How Much Money You Should You Keep in a Savings Account
All else equal, and speaking in a broad, academic sense, the answer is simpler than it might appear. The amount of money an investor should keep in a savings account is going to be based on a handful of factors, including:
- The stability of his or her employment situation or another primary source of income
- The level of fixed expenses he or she incurs each month
- His or her desired standard of living
- The probability of large demands on his or her resources, particularly those that might arise on short notice
- The amount of cash he or she needs to feel secure, which is purely an emotional consideration that will differ from person to person and even from year to year based on the stage of life
Let's take a moment to examine a few of these more in-depth so you can get an idea of the cash levels that might be appropriate for a personal savings account.
Be Honest About the Stability of Your Income Situation
Are you a tenured professor at a prestigious Ivy League university with dozens of published books, a booked schedule of lucrative paid speaking gigs, and a side career as a high sought-after expert, all of which come together to produce a mostly stable, lucrative, six-figure income or are you a temporary worker in a seasonal industry that faces boom and bust times so you never know if you are going to have a job next quarter?
Even if the incomes were identical, the latter person would need to have several times the level of cash sitting in a savings account to adequately protect his or her family from potential disaster because the latter person is subject to greater personal liquidity shocks.
Another alternative is to follow what I call the Berkshire Hathaway business model. Over the course of many years, you can greatly reduce your risk by constantly adding new streams of income. Whether you are an attorney who owns a chain of ice cream shops, or a geology professor who has built up a portfolio of master limited partnerships gushing oil, natural gas, and pipeline profits into your checking account, the more diverse your cash flow, the less you have to rely on a single activity or operation to keep the lights on and food in the pantry.
Calculate Your Level of Fixed Expenses
The next step when trying to determine how much money you should keep in a savings account is to look at your fixed expenses. If you lost all of your income overnight, how many months could you maintain your standard of living? Most experts recommend a six-month reserve.
Personally, I think most people should consider at least one to two years. It's more ambitious, but realize you don't have to build that reserve overnight. You can work at for years, slowly accumulating your surplus. Another way you can achieve it is by reducing the cash demands on your family's finances. For example, you might pay off your mortgage earlier than its stated maturity. With no mortgage payment, your emergency fund sitting in a savings account doesn't need to be as large, giving you more money to invest or spend.
Figure Out If You Are You Exposed To Any Large Demands On Your Cash Reserves
Are you facing the threat of a major lawsuit? Is there the potential for significant medical bills? Is your family-owned business suffering a decline in revenue? If so, consider hoarding cash in a savings account. One of the worst case scenarios is that you end up having too much money on hand. That's a high-class problem to have. If nothing comes of it, you can always buy an asset to generate passive income next month or next year.
Look Inside and Honestly Assess How You Feel Emotionally
This differs for everyone, and, again, it may even change based on the phase of your life. How much money would it take, sitting safe and secure in a savings account, for you to sleep well at night and not worry? You probably have a figure, even if it is irrational, that comes to mind immediately.
For some people, it is $10,000. For others, $100,000. Billionaire Warren Buffett likes to keep $20 billion minimum around, though he parks it in Treasury bills, bonds, and notes, not a savings account. We each have "a number". Figure yours out by being honest with yourself and then find a way to make it happen.
Please note that The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.