The Problem With Too Much Cash

If you are a long-time reader of my Keep It Easy newsletter, you know I beat this drum over and over and over: I want everyone to maintain enough cash in an interest-bearing, FDIC-insured savings account to cover a minimum of 3 months’ worth of expenses. If you’re self-employed or have an up & down income, you should bump that number up to 6 months’ worth of expenses at a minimum. And maybe if you’re especially cautious, you might feel more comfortable aiming for a full year’s worth of expenses in the bank.

Regardless of your situation, this is something I want everyone to do. Having a bunch of cash on the sidelines will seem like the smartest decision you’ve ever made when something comes up and you need that money.

We can call this an emergency fund, and having a bunch of cash certainly does help you navigate an emergency. But we can also think of it as a “sunny day fund”: money available to help you act on big opportunities or say yes to exciting adventures. So maybe a friend suggests a fun trip on short notice and, because you have that cash, you can say yes. Or maybe that means you can pursue a bigger job opportunity or launch your own business because you don’t have everything riding on your next paycheck.

There is so much utility in having the right amount of cash available at all times and, if you keep it in an FDIC-insured account, there is literally no downside. When you see that a bank account is FDIC-insured, that means that the government is guaranteeing the safety of your deposits up to $250,000 per person per institution. So money in an FDIC-insured savings account is ultra-stable, ultra-secure, and it’s there when you need it.

So I will say it again and again: I want everyone everywhere to build up this kind of a savings account. For all of your short-term financial needs, cash is king. 

But here’s something I’ve noticed among lots of people—and especially people with unstable jobs, like musicians or authors or anyone who runs a business—they tend to have a hard time putting extra money to work for them by investing it, even when they manage to save more than enough cash to cover that emergency fund. And this is often uncorrelated to how much they earn or how much they already have in a bank account. My hypothesis is that, because there is so much instability in their careers, they tend to overcorrect by prioritizing short-term security over everything else when it comes to money.

And it feels really smart while you're doing it: we live in an unstable world with an unknown future, so why take a bunch of extra risk with your money? Sounds reasonable, right?

But here’s the rub: in the long-term, keeping too much of your money cash is actually a liability. In other words, even though the right amount of cash can be a lifesaver, too much cash is actually a problem. Let me tell you why.

If you’ve been pretty much anywhere in the entire world in the last five years, you’ve probably heard a lot about inflation. And you see it everywhere: your groceries cost more, your utility bills are higher, going out to dinner costs more, and even decent used cars cost about the same amount that new cars did just a handful of years ago. Now, it’s been an intense few years for inflation, but even in “normal” years inflation still slowly creeps higher and erodes your buying power over time.

That means that every year the value of cash declines a little. It buys just a little bit less than it did last year. And, given enough time, the buying power of each dollar goes down a lot. 

So, while cash is essential to solving short-term problems, it’s actually terrible at solving long-term problems. Long-term problems need long-term solutions. And that’s where investing comes into play.

When we talk about investing, most of the time we’re talking about the stock market. And, in the short-term, the stock market is extremely volatile. It’s unreliable. It’s risky. The price goes up and down and down and up over and over again, 6 ½ hours a day, five days a week, with only a handful of breaks for holidays. Whereas cash is extremely stable in the short-term, the stock market is extremely unstable; you just can’t really count on it to do what you want when you want.

But a funny thing happens if you wait long enough: whereas cash is safe in the short-term but lousy in the long-term, investing in the stock market is very unstable in the short-term but tends to be incredibly resilient in the long-term. If we can frame things in terms of 5-10+ years, stocks have actually been extremely reliable for growing wealth over the last century. And they tend to do a better job of outpacing inflation than just about any other asset class in the long-term.

And by the way, that’s true even when we factor in things like the Great Recession, the Dot Com Bubble, and all the way back to the Great Depression. Over long periods of time, the stock market has been amazing at building wealth for investors just like you.

Consider this: every year, your cash loses on average 2-3% of its value due to inflation. And over long periods of time, stocks tend to gain on average 9-11% per year. So not only does keeping too much in cash mean that your money loses value over time, but it also means you’re missing out on all the potential long-term upside from investing. That’s a difference of potentially 11-14% every year when you don’t invest excess cash. And that’s a huge missed opportunity! It could literally be the difference between just getting by for the rest of your life versus being able to afford a better, more comfortable life with better, more interesting options as you get older.

So what’s your average person supposed to do with this conundrum? No one wants to take on too much risk, but we also don’t want our buying power to keep shrinking because of inflation.

I find it really helpful to focus on the distinction between money you need for right now (in other words, cash) and money you need later on (in other words, investments). If you can think of investments as money you need later—potentially for the rest of your life—and not money that you need right now, that gives you the mental breathing room to stick with it for a really long time, which, not coincidentally, is when investments do the best: over long periods of time.

One helpful metaphor is called the barbell model. Picture a barbell in your mind: it’s really heavy at both ends, but those ends balance each other out. If one side is too heavy, it doesn’t work. But we’re not talking about weight or a dollar amount here: we’re talking about risk. Too little cash is a problem, too much cash is a problem, but the right amount helps you balance out the inherent volatility of investing. And, just like a real barbell, when you can balance the risk you take with your money between cash on one side and investments on the other, it makes you stronger. 

When you understand that the extremely low short-term risk of your cash is a counterweight to the short-term volatility of your investments, that gives you the freedom to let your investments grow for a very long time. Which, again, is exactly the time frame in which investments are most successful.

Another helpful approach is to remember that stocks aren’t the only game in town when it comes to investing. It’s true that the stock market tends to be excellent at growing wealth over the long-term. And I want everyone to participate in the stock market. But that doesn’t mean that all of your investments need to be in stocks or stock funds. When I manage investments for people, I always balance less risky investments like bond funds or even cash in money market funds against riskier investments like stock funds. That way you can get the right amount of growth for you and your timeline while also smoothing out some of the peaks & valleys along the way. 

And finally, it’s also helpful to remember that none of this needs to be an all-or-nothing proposition. 

If you’re still working to build up that savings account to cover your short-term needs, that’s a priority – but it doesn’t mean you can’t also use some of your cash for other purposes, even if it’s a relatively small amount. So while you’re building up that savings account, you can also overpay your debt payments each month or invest a little money each month, or all of the above. Compounding interest is a powerful concept, and overpaying your debt and/or investing with even $100 a month will help you in the long run, and the longer you do it, the more powerful the impact.

And if you already have more than enough cash to cover your short-term needs, that doesn’t mean that everything needs to get invested all at once today. You can do it a little bit at a time to minimize the risk that you’ll invest everything right before a market downturn. Nobody wants that! So find an approach that works for you. If that means you slowly move extra cash to investments over the next 12 months, that’s totally fine. What’s most important is that you have a plan to invest that extra money and stay committed for the long-term, which is honestly the only time frame that really matters.

If you want to get started on this and don’t know where to begin, a great first step is to get an idea of what you spend every month. That could be in the form of a budget, but you could also just add up all the money that left your bank accounts over the last 3 months and divide by 3. That’s close enough to get started. Then define some amount that will make you feel safe & secure—3 months’ worth of expenses is the minimum, but lots of people (like self-employed people) should aim for 6 months’ or more.

And finally, when you get that amount of money in your savings account, don’t move the goalposts! If you need a whole year’s worth of expenses in cash to feel secure, that’s totally fine. But commit to that number and resist the temptation to bump it up just a little bit when you get there. It’s such a big temptation and I see lots of people make that mistake.

So, if you only take one thing away from this post, please remember this: enough cash in the short-term is an incredible advantage, but to build real stability and security, you need to also be investing for the long-term.

If you want to have a conversation about your financial health or investing for the long-term, hit me up. This email address is always checked by yours truly.

Thanks,

Timothy Iseler, CFP®

Founder & Lead Advisor

Iseler Financial, LLC | Durham NC | (919) 666-7604

Iseler Financial helps creative professionals remove stress while taking control of their financial lives. We'll help identify current your strengths and weaknesses, clarify and refine your long-term goals, and prioritize decisions to improve your financial well-being now and later. Reach out today to take the first step.