At some level, I think everyone knows how important having cash on hand is. It helps pay the bills. Your mortgage. A bite out to eat. A new pair of pants. Obviously, you can use credit cards to pay for all of these expenses, but without the cash to pay your credit card bills off in full at statement close, you’ll end up trading in your burgers and jeans for debt (or to think of it another way, those fifty dollar jeans might end up costing a whole lot more than fifty bucks).

Emergencies

Cash is also critical to deal with the plethora of emergencies that can crop up. Your furnace needs to be replaced. You get seriously ill and need to go to the emergency room. Your company downsizes and you get laid off. Again, these are places where credit cards will sometimes be deployed (or worse, payday- or 401(k)-loans).

For this reason, it’s critical to have money set aside to deploy in times of need (the oft-discussed “Emergency” or “Rainy Day” fund). How much money you should have saved is debated: $1,000 is a popular suggestion, as is 3-6 month of living expenses (although at least one financial expert says 8-12 months).

In my mind, the amount you need for emergencies is highly dependent on:

1. Your ability to find a new job. If you work in an industry where your skills are in high demand, you likely don’t need as much as an industry in low demand. For example, software engineers probably don’t need to save as much for emergencies as coal miners.
2. How many people depend on your income. The more people depend on your income, the more critical it is that you can cover this income in case of a job loss. If you have ten kids, the goal should almost certainly be closer to six months at a bare minimum.
3. If you are a homeowner or a renter. Homeowners can often have more variable costs than renters. If an appliance breaks down and you rent, you typically just ring up your landlord and it becomes their problem. Not so when you own.

Beyond Emergencies

Hitting the three to six month emergency fund goal is the end of the cash line for most… from here, people will move on to other investments (stocks and real estate being popular choices). Who wants to hoard tons of cash when savings account interest rates are so anemic?

I do!

While it’s very true that savings accounts barely keep up with inflation at best, hoarding additional cash does have several major upsides:

1. Invest more aggressively. Historically, the most significant danger in stock investing is time… over a year or two, you can potentially lose (or gain) significant amounts of money, but over many years, stocks nearly always lead to net gains. Therefore, the best way to invest in stocks is to buy and hold for as long as possible. More cash significantly reduces the need to tap the investment prematurely or unexpectedly. Adding to this risk is one of the major reasons you’d need to tap your investments in the first place: job loss. A recession has the potential to dramatically retard your investments while at the same time causing layoffs. More cash helps mitigate this risk.
2. Opportunities. The best time to buy is when everyone else is selling. Keeping extra cash means that a market downturn allows you to place extra money into the market when prices are depressed (if desired).
3. Increased (but incomplete) independence. More cash means the ability to survive without cashflow for a longer period of time. That means that if you get into a place where you need to make a change (for example, a bad manager at work), you have the ability to do so without the need to immediately replace your income.

Infinity

While I’m a strong advocate in keeping a larger pool of cash, it is important to not go too overboard… there is a point in which the opportunity costs of not investing your money, plus the consequences of inflation make keeping outrageous amounts of cash a bad idea.

I suggest picking a target early on and sticking to it. If you are anything like me, the temptation to hoard just a little bit more is real, so having a hard cap will keep things reasonable.