Cash: How much do you really need on hand?

Many people say, “Cash is king.” Others say, “Cash is a drag.” Which is it? How do you know if you have too much or too little cash? And what should you do about it? One reason there are so many different views of cash is that it doesn’t just mean one thing. Having access to cash is much more than having funds in bank accounts for unexpected expenses or life events. Cash includes lines of credit, money market funds, short duration fixed income and more. But how do you know which banking, investing and lending products are right for you, based on what you’re trying to accomplish with your money?

Assigning your money (assets) to different buckets of wealth can help you organize—and utilize—your money in ways that support your intentions. To learn more about the power of bucketing your wealth, see here.

One of those buckets, which we call the liquidity bucket, is for cash. There aren’t “good” or “bad” choices when it comes to cash decisions. Instead, you want to be intentional. Here’s how to thoughtfully create a liquidity bucket for your family’s financial life. We’re including a framework to help you get started, questions to think through, strategies that may be well-aligned with your needs and, finally, common behavioral biases that can influence the decision-making process. 

A framework for your liquidity bucket

The purpose of the liquidity bucket is to give you access to money at all times for whatever reason, so that you have a foundation for financial security and the confidence to address anything that comes your way. This bucket allows you to live your lifestyle without having to constantly monitor what money is coming in and going out. It can help you feel psychologically safe – especially in volatile markets - and avoid selling investments at inopportune times. When money is easy to access it can enable you to buy a Large capital expenditure or address an unexpectedly large payment (e.g., taxes) without having to scramble. 

Here are four categories that you can use to identify your liquidity needs: 

• Operating cash flow: Cash to cover day-to-day expenses for 1-5 years
• Psychological safety net: The amount of cash that helps you sleep well at night
• Large capital expenditures: Cash earmarked for any big purchases or financial commitments in the near term
• Opportunistic funds: “Dry powder” to take advantage of compelling investment opportunities that may arise

Questions to ask yourself

Operating cash flow: What is your family’s annual “run rate?” How much cash do you need for essential and discretionary expenses? Is an expense truly discretionary or do you really consider it as non-negotiable for your family? Do you have a buffer included for the “one time” expense that typically pops up on an ongoing basis? (We all seem to have this one; it might be a new car one year, home improvements the next, etc.) Are you relying on your portfolio for all of your cash flow needs or are you still earning income? How liquid or illiquid are your longer-term investments?

Large capital expenditures: Do you have any planned big purchases or outlays over the next 18 months, such as a real estate purchase, capital call or tax payment? In this same spirit, are there any outsized inflows that you anticipate that could cover these outflows, or should distinct cash be set aside? Are you flexible with the timing of these outlays or is their timing fixed?

Psychological safety net: Do you have enough cash on hand to feel safe? Does it allow you to comfortably weather market volatility, potential business interruptions or other uncertainties that are out of your control? Is there a particular amount that would permit you to take prudent risk in the rest of your investment portfolio?

Opportunistic funds: How much do you want to set aside as “dry powder” for timely investments should they appear? Do you feel strongly about having actual cash for these investments or would access to liquidity through a line of credit be acceptable?

Common approaches

Within the liquidity bucket, you can choose among a range of products across banking, investing and lending. Your time horizon (when you’ll need the cash) and your own risk tolerance will determine which strategy makes the most sense for you.

For example, the liquidity you need for a home purchase 12 months from now could be handled differently than the cash that you’ll need over the next month for your day-to-day operating expenses. And it will be different still from the liquidity that is available “just in case”—as either a psychological safety net or opportunistic funds for timely investments. 

Behavioral biases

Implementing the optimal approach for your liquidity bucket may be easier said than done. It’s human nature to hold more cash than we need, even when we know it could be put to better use. The numbers, the data, the well-thought out plan … they could all be right in front of our faces, but we still might choose to keep money on the sidelines. Understanding why we would do that is the first step to creating a mindset that helps us get the most out of our financial resources.

There are many behavioral reasons why we hold on to cash. Here is a short review of the most common principles at play:

Loss aversion

Loss aversion—in which we are more motivated to avoid loss than to pursue gain—is one of the most powerful forces in behavioral finance. The pain of losing $100 is only matched by the pleasure of winning $200. This drives us to keep our cash out of investments because we’re afraid of losing it.

Present bias

Present bias is the principle that explains why, for many of us, now matters more than later. The emotions of the present greatly outweigh the potential benefits of the future. In fact, we consider our future selves to be completely different people than us. While doing something right now feels good, doing something for our future elicits close to no emotional response. That’s why it’s so hard to do things that will help our tomorrow—whether it’s exercise, eating healthy, or letting go of our cash— today.

We connect to our cash now more than our investment outcomes later.

Control

The need for control is a basic motivator of human behavior. Since cash is the most tangible, fungible, accessible and emotionally salient form of money, holding on to it offers us the feeling of control. 

These behavioral traps can actually become opportunities. If we invest our money with intention, we take control of our future and avoid losing ground in pursuit of our financial goals. Thinking of our cash deposits in this way allows us to use our natural human biases for our own good, instead of having them work against us.

Final thoughts

As you consider how much liquidity or cash you need on hand, be specific about what exactly it is you’d like to do with it. Here’s an example of how you could align capital from your overall portfolio into a liquidity bucket.

Cash is neither good nor bad. Actual cash, cash equivalents (money market funds and T-bills) or access to cash via a line of credit can all have a place in our wealth strategy. What matters is being intentional in deciding how much to keep in our liquidity bucket and how it could impact our overall goals. It helps to understand the behavioral forces at play when we decide how much liquidity we need. Then we can identify the appropriate strategies to keep us moving forward on our own personal wealth journey.

For a more detailed discussion on this topic, please contact your J.P. Morgan team. They are always available to answer your questions and to help you with any of your financial planning needs.