When it comes to personal finance, there’s no end to the emphasis on how important it is to save. I’m part of that choir myself!
You probably already know all the financial fundamentals for success, because they are repeated everywhere:
Build an emergency fund. Set money aside for big goals. Keep cash on hand.
But have you ever wondered if there’s a point at which you actually have too much cash on hand?
If so, you’re asking a good and valid question, because the answer is yes.
Yes, you can have too much of a good thing, and there’s a point at which more cash in the bank is actually doing more harm than good.
Here’s what that means and why holding onto excess cash can actually put a damper on your financial future.
The Correct Amount Of Cash To Keep On Hand
It is generally a good thing to keep money liquid and easily accessible in places like bank savings accounts.
The first layer of cash you want to have available is whatever you need to manage your monthly cash flow – which is money coming in and money going out.
You need enough in the bank to handle the moving parts of your everyday finances, from bill pay to normal expenses and everything that happens in between pay periods.
Above that, you should also keep cash on hand for emergencies.
Like most other financial experts, I typically recommend that my wealth management clients keep 3 to 6 months’ worth of normal expenses in cash to cover the unexpected.
The precise size of your emergency fund will depend on a few factors, including how (and how often) you get paid, how flexible or fixed your expenses are, and how exposed you are to financial risks and obligations.
The emergency fund of someone with a steady full-time job with no dependents and a rental apartment, for example, will likely look very, very different than someone who is self-employed with two children and a mortgage.
When determining what your emergency fund should consist of, consider factors like:
- Your job stability. If you work for a startup, are self-employed, or have an unpredictable income, you may want to keep more cash on hand than someone with a stable, salaried position.
- Your financial responsibilities. Do you have a mortgage? Dependents? High fixed expenses? If you have more financial obligations, you may need to keep a larger emergency fund.
- Your personal comfort level. Some people just feel better knowing they have a year’s worth of expenses in cash, even if they don’t technically need that much. Having peace of mind is well worth keeping a little more in cash than you strictly “should” have in the bank.
Finally, you’ll want to account for short-term savings goals or spending needs when determining how much cash is appropriate to keep in the bank.
If you need to fund a goal that you want to achieve in 3 years or less (like buying a home or going on a really nice two-week vacation), you should likely keep that savings in cash for liquidity and safety.
Similarly, if you know you need to pay for a home renovation in the next year or will have a big school tuition payment coming up in 6 months, make sure that money stays in a bank account, ready and accessible when it’s due to be used.
Why Holding Too Much Cash is a Problem
It’s easy to think that keeping excess cash above the amount you actually need to run your financial life and provide some protection and liquidity is a savvy move to make.
After all, it’s just sitting there in the bank. It’s not harming anything, and it’s not at risk…
Right?
You might think so, but this belief is misguided because cash will lose value over time thanks to inflation.
A few years ago before the pandemic, a good interest rate on a savings account might have been around 1.85%. Inflation averaged a little over 2% per year, meaning the price of goods and services rose faster than earnings on cash.
Fast forward to today, when interest rates on savings accounts are higher. They can easily range from 3 to 5 percent.
But inflation spiked in the pandemic years, too, far outpacing even the best and highest interest rates on any bank account.
Even when you could earn high above the historical average of about 1 percent on your cash, it still wasn’t enough to keep up with inflation – let alone beat it.
In practical terms, this means keeping too much money in the bank could actually prevent you from being able to afford your lifestyle in the future when you want to stop working.
This is why savings is important… and contributing some of that savings to your investment portfolio for long-term growth is critical.
A modest portfolio can reasonably expect to earn about 6 percent in returns over time. That is sufficient to match or outpace inflation and it is significantly more than cash in the bank will provide.
Inflation Isn’t The Only Cost – Missed Opportunities Add Up, Too
In addition to inflation risk (which is what too much cash in the bank is subject to), money sitting around without a job exposes you to opportunity costs.
If you’re holding money in cash that otherwise could be invested, you’re missing out on long-term growth.
The stock market has historically returned around 7% per year after inflation. Compare that to the 1-2% interest you might earn in a savings account, and the difference over time is staggering.
Here’s an example:
- Scenario 1: You save $200 per month in cash for 10 years. After 10 years, you have $24,000.
- Scenario 2: You invest $200 per month in the market for 10 years, earning an average 7% return. After 10 years, you have about $34,000—$10,000 more than if you only saved but did not invest.
And that’s just 10 years. The more time you give your money to be in the market, the more you will benefit from compounding returns.
When you let cash sit around for too long, you’re losing time—and when it comes to growing wealth, time is your most valuable asset.
What Should You Do With Excess Cash?
You do need cash on hand. You want to have enough money in the bank to cover your normal monthly expenses, enough so you have access to cash in case of emergencies, and anything that will fund a short-term savings goal or spending need.
But anything above this amount could actually hold you back from what you want. Having too much cash sitting in a bank account where it cannot go to work for you presents risks to your long-term financial goals.
So once you determine how much you truly need to keep in cash and you find you have more than that amount in the bank, what should you do with the rest?
Put it to work for you. Get your money earning more money.
In other words, invest in some kind of growth asset.
Investing allows your money to grow faster than inflation, so it can actually increase your purchasing power over time.
If you’re nervous about investing—especially in a volatile market—it can be helpful to remember two key points:
- Historically, financial markets increase in value over time. The stock market has trended upward over long periods (meaning, decades of time). Short-term volatility is to be expected along the way, but over the long-term, we expect to see growth on investment portfolios.
- Time in the market is more important than timing the market. Trying to predict the perfect moment to invest is nearly impossible. The key is to start early and stay invested. The best time to start tends to be yesterday – and the second-best time is always right now.
Assuming you have cash to invest, research from Vanguard suggests that putting it in the market all at once tends to outperform periodic infusions to your portfolio over a period of time.
But if you’re nervous about deploying a lot of cash in the market, it is not unreasonable to break a lump sum into smaller chunks. If you have $50,000 to invest, for example, you could invest $8,333 per month for six months to ease your way in.
Getting started is the most important part, so do what feels most comfortable to you.
Holding a lot of cash in the bank may feel like the absolute most comfortable option, but don’t be deceived. Cash drag can create a large and unnecessarily risk to your long-term wealth.
Get an honest tally of how much cash you need. If you have more on hand, make sure your money is working as hard as you do.