Make Your Extra Cash Work For You
Many times, people have come to me with concerns about cash buildup in their savings accounts. That's not a bad problem to have, but it's still a problem.
Some people are concerned about spending their extra cash, while others are concerned that they're not investing it. In either case, this situation can easily be avoided through a simple process that makes your cash work for you.
What Happens to your Extra Cash When You Don't Have a Process?
When money starts building in your savings, it feels good and can increase your financial confidence. That's helpful, but there comes a point when too much cash creates overconfidence.
The risk of too much confidence is that you might spend too much of your cash, invest it unwisely, or even just let it sit. The bottom line is that this money has no job. Every dollar you have should work for you in some way, even when it's not being spent.
Your Extra Money has Two Jobs
The money building up in your savings has two jobs, and it's up to you to understand how much you need set aside. You could spend a lot of time contemplating this, but I'll tell you how to broadly figure out your saving needs.
1. Cover Emergencies
First, you need money for emergencies. Think about the worst, probable scenario. Not the worst possible, just the worst probable. For most people, that's losing their job. If your income went to zero, realistically speaking, how long would it take you to find another one?
Realize, I'm not talking about finding another job today, but finding another job in the scenario where you've been let go from your current position. The economy is probably doing much worse, the tech industry is stumbling so other firms aren’t as eager to hire, etc.
If you think it will take you six months to find a new job, then your emergency fund should cover six months of your current lifestyle while you search for your next position
2. Cover Future Big Expenses
Second, you need money to cover purchases over the next 5 years that are above your expected income. Think of the really big expenses, like home remodeling or unpaid sabbaticals.
Now, add your emergency fund and future big expenses (that won't be funded by income) together, and that's how much you should have in savings.
What Happens to the Rest of the Money?
If you have more than amount we figured above, then that money might be working against you. It needs to go into your long-term investment portfolio.
All of your investments, whether they are in your 401k, IRA, or regular taxable account, make up your long-term investment portfolio. Please note this should be viewed as a single portfolio that is designed to provide you long-term returns, and that the downside during market crashes shouldn’t make you freak out and sell.
If you have extra cash lying around, give it the job of funding your long-term expenses (more than 5 years from now) by being part of your long-term investment portfolio.
What if You Don't Have Enough Savings?
If you don't have enough savings to cover your emergencies and future major purchases, then there are a couple things to check:
Is your Spending Plan correct? If not, adjusting your Spending Plan could change your emergency fund target (less spending means a lower target).
Are you truly committed to the extra spending you planned over the next five years? Perhaps some of it depends on higher bonuses or greater stock compensation in the future. If so, you don't need to reserve money for those expenses today because they’ll be paid by your future higher income.
If, after considering the above, you still don't have enough savings, then your extra savings in the coming months need to fill up the gap before any extra investing.
At the End of the Day, Every Dollar Should Work for You
Any funds you invest have at least 5 years to grow, and any savings you have is earmarked for either emergencies or future planned spending. With this process, you'll gain clarity and control over your personal cash flow.