Checking accounts, savings accounts, money market funds, these are the things we usually think of as cash. On the other hand, you have your regular investments. Stocks, mutual funds, gold, real estate, art; these things are certainly valuable but not as easily converted into cash.
The problem is, how do you determine how much of your wealth to keep in cash, and how much to keep in non-cash items?
You never know when you’re going to have an unexpected emergency. Things happen and when they do you need to be able to put your hands on as much cash as you can. But if most of your wealth is in the form of your house for instance, and you suddenly had an emergency where you needed to raise a large amount of cash, you would be in trouble.
So it’s important to always keep cash or cash equivalents on hand, the problem is how to determine how much cash. Keep too little cash and inflation eats away at the value of your wealth. You always have to invest in some long-term assets that will at least keep up or beat inflation.
Everybody is different, everybody has different risk tolerance levels. Some people will be comfortable keeping $1,000 to $5,000 in cash available for emergencies, some people will not feel secure unless they have $50,000 to $100,000 in cash available. It really just depends on you.
A good rule of thumb to use is to figure out what you would need for 3 to 6 months of expenses. For some people keeping six months worth of expenses in cash is not a realistic goal. If that’s the case then I suggest keeping three months worth of expenses in cash. That way if something happened, for instance if you lost your job or your spouse lost their job, you would have enough money set aside in cash to pay all your expenses for three months.
Of course, hopefully you have your other long term investments that you can liquidate within those three months to tide you over when the three months of cash runs out. If your long-term investments are less liquid, that is, if you think it will take longer than three months to turn them into cash, you should plan for this and keep more cash available.
Whatever your risk tolerance ends up being, having a plan in place before hand can be one of the most important parts of any long-term financial plan that you may come up with. So many people don’t have any kind of plan in place at all. Even if your plan is slightly incorrect, any plan; even a poor plan, is better than nothing.
And as they say… when did the man build the ark? Before the rain…