With inflation on the rise and interest rates still near historic lows, many people are wondering if it makes sense to keep their money in cash these days. Cash may seem like a safe place to park your money – after all, it’s FDIC insured and you won’t lose principal like you could in the stock market. However, the reality is that inflation eats away at the purchasing power of cash over time. Holding large sums of cash may prevent you from losing money in the short term, but it can erode your purchasing power in the long run.
What are the pros of keeping money in cash?
Here are some of the potential benefits of keeping some money in cash:
- Liquidity – Cash is incredibly liquid. You can access physical currency immediately to pay for things if needed.
- Stability – Cash does not fluctuate in value like other assets. You know exactly what a dollar is worth from day to day.
- FDIC insured – Cash deposits in U.S. banks are insured by the FDIC up to $250,000 per depositor, per institution. This protects your money in the unlikely event of a bank failure.
- Avoidance of market risk – Keeping money in cash prevents exposure to volatility and losses in the stock market or other risky assets.
- Peace of mind – For some, holding cash provides comfort and security knowing they have those emergency funds readily available.
Having some cash on hand can provide liquidity, stability, and peace of mind. Just be aware of its limitations when inflation is high.
What are the cons of keeping money in cash?
While holding cash has some benefits, there are also some significant drawbacks to consider:
- Inflation erosion – Cash does not earn any interest or appreciate over time like other assets. Inflation chips away at the purchasing power of cash.
- Lost opportunity cost – Keeping money in cash means missing out on the potentially higher returns from investing in stocks, bonds, real estate, etc.
- No compound growth – Unlike assets that generate returns, there is no compound growth effect on cash over time.
- Not suitable for long term holdings – Cash is best used for short term needs. It should not make up the bulk of savings meant for long term goals.
- Need for active management – You have to periodically re-evaluate your cash holdings and make adjustments to keep up with inflation.
The biggest risk with holding cash long term is that inflation will erode the purchasing power of your money over time.
How does inflation impact cash savings?
Inflation measures the rate at which prices rise in an economy over time. It reflects the decrease in the purchasing power of a currency. For example, with 3% annual inflation, something that costs $100 today will cost $103 next year.
When inflation is high, cash and fixed income assets like bonds see a decline in real value and purchasing power. The fixed number of dollars you have buys fewer goods and services.
Here is an example of how inflation could eat away at the purchasing power of cash savings over 30 years:
| Year | Amount in Savings Account | Inflation Rate | Purchasing Power |
|---|---|---|---|
| 1 | $10,000 | 3% | $10,000 |
| 5 | $10,000 | 3% | $8,683 |
| 10 | $10,000 | 3% | $7,441 |
| 15 | $10,000 | 3% | $6,384 |
| 20 | $10,000 | 3% | $5,487 |
| 25 | $10,000 | 3% | $4,720 |
| 30 | $10,000 | 3% | $4,065 |
Even though the nominal amount stayed the same, the purchasing power of the cash was reduced by over 60% over 30 years due to inflation.
How can you minimize inflation risk?
Here are some steps you can take to help minimize inflation risk to your cash savings:
- Limit cash holdings – Only keep enough cash on hand for near term expenses and emergencies. Don’t try building long term savings with cash.
- Invest excess cash – Investing allows you to earn returns that can outpace inflation. Consider stocks, bonds, real estate, etc. if you don’t need the money short term.
- Use inflation-protected securities – Treasury Inflation-Protected Securities (TIPs) or I-Bonds help protect against inflation.
- Maintain an emergency fund – Having 3-6 months of living expenses in cash is wise, but avoid stockpiling too much cash.
- Consider CD laddering – This can let you earn higher yield on cash you won’t use immediately.
- Be a diligent shopper – Seek out deals, sales, and discounts to make your cash savings go further when you do spend them.
Diversifying your savings across asset classes and being proactive about maximizing returns can help minimize inflation-related risks. It’s about balance – having access to short term liquid cash while keeping long term purchasing power.
How much cash should you keep for emergencies or liquidity needs?
The amount of cash you should keep on hand depends on your personal financial situation:
- Emergency fund – Many experts recommend having 3-6 months of living expenses set aside for emergencies like job loss, illness, or major home/car repairs. For most, that means aim for around 6 months.
- Known upcoming costs – If you have big ticket expenses coming up soon like a down payment, taxes, or vacation, keep that cash set aside.
- Consistent monthly spending – Having 1-2 months of cash to cover consistent monthly costs ensures you have money for bills even if income is delayed.
- Job stability – Those with stable jobs who are confident in their income continuity may need closer to 3 months set aside. Those with unstable jobs may want 6-12 months of reserves.
- Debt obligations – The more debt payments you have each month, the more cash you may want to have on hand for flexibility.
- Health concerns – Those with chronic health conditions may need larger cash reserves to manage medical costs and prepare for unforeseen issues.
As a general guideline, most experts recommend a cash emergency fund of 3-6 months of living expenses. But your unique situation may require adjusting that amount up or down. The key is not keeping more cash than you need long term while still having adequate reserves for life’s unpredictability.
How can you earn interest on cash savings?
While cash in a savings account does not earn much interest these days, you do have some options for generating a return on your cash holdings including:
- High-yield savings accounts – Online banks tend to offer the highest interest rates on FDIC-insured savings accounts, typically well above traditional banks.
- Money market funds – These mutual funds invest in short-term, low-risk debt securities and pay dividends that can be withdrawn like cash.
- CD laddering – Buying CDs with staggered maturity dates lets you earn higher rates while maintaining access to cash.
- Treasury bills – These short-term government-backed investments pay interest and provide stability of principal like cash.
- Ultra short bond funds – Invests in short duration bonds with higher yield than a savings account but with only minor increased risk.
- Cash management accounts – Some brokerages offer FDIC insured accounts that pay higher interest on uninvested cash balances.
Shopping around for the best rates, laddering maturity dates, and exploring stable short duration income investments can help boost yields on cash savings above a basic savings account. Just be sure to weigh the risks.
Should you invest cash you may need in the near term?
As a general rule, only cash that you know you will not need to access in the next 3-5 years should be invested in securities like stocks and bonds. Money that you may need to tap in the near term should be kept in stable cash savings or cash alternatives.
Investing comes with market risk and the possibility of losses. So cash needed for near term expenses should not be exposed to that volatility.
Here are some factors to consider when deciding what cash to invest:
- Known upcoming costs – Down payments, taxes, vacations, etc. Keep cash needed in the next 1-3 years safe.
- Emergency fund – 3-6 months of living expenses should be kept in cash savings as your emergency buffer.
- Job stability – If your income is less certain, you may want more cash reserves on hand and invest less overall.
- Market conditions – When markets rise sharply, taking on less risk may be prudent until pullbacks occur.
- Your risk tolerance – More conservative investors should keep more in cash and only invest what they are comfortable losing.
In general, investing cash you are highly likely to need in the next 3-5 years exposes you to unnecessary liquidity and market risk. But cash that can be locked away for long term growth can be invested more aggressively.
What are alternatives to cash savings for part of your portfolio?
Here are some asset classes and securities you may want to consider holding in addition to an emergency cash fund:
- Bond funds – Can generate income while providing more stability than stocks. Shorter duration bonds see less price fluctuation.
- Dividend stocks – These stocks make regular distributions to shareholders. Blue chip stocks often have high but stable dividends.
- Real estate – Rental property, REITs, and real estate funds can provide inflation protection and diversification.
- Commodities – Gold, oil, metals, and other commodities can hedge against inflation
- Inflation-protected securities – TIPS and I-Bonds increase their principal value with inflation.
- CDs – While paying low rates, certificates of deposit are FDIC insured up to $250,000.
- Money market funds – These mutual funds offer higher yield than savings accounts with check-writing access.
Maintaining an optimal asset allocation is crucial. Blending cash savings with less liquid assets that hedge inflation can help balance short-term spending needs with long-term growth.
Conclusion
Determining how much cash to keep involves assessing both your short-term liquidity needs and your longer-term inflation risk. While cash provides stability and liquidity, holding too much can expose your savings to inflation erosion over time.
Aim to have 3-6 months of living expenses in an FDIC insured emergency fund. For the rest of your savings, consider investing in assets like stocks, bonds, and real estate to earn inflation-beating returns. Maintain a diversified portfolio with an appropriate allocation of short-term cash, near term income investments, and long-term growth assets based on your specific needs and risk tolerance.
Being strategic with cash holdings, exploring yield-generating cash alternatives, and investing the rest in assets with growth potential can help maximize returns on savings in both the near term and over your lifetime. Monitor inflation carefully and adjust your cash allocation as needed to maintain adequate liquidity and returns.