September 3rd, 2015 | David Simpson

Why cash is a good thing

How do you plan to cover your planned and unplanned expenses for the next six to twelve months? Do you plan to cover those expenses by selling a certain stock, bond, or mutual fund? How do you feel today about a particular investment versus your feeling on that same investment yesterday or last week? What if a good or bad news event comes out and affects that investment and/or your feelings about it? The past couple of weeks have caused a lot of upheaval (think small boat and large waves) in the various stock markets around the world. What if, all of the sudden, you had to cover expenses that you knew about in advance but did not have the cash available so you had to sell when markets had dropped?

By designating a pool of cash, shorter-term bonds, or certificates of deposit to cover expenses, you remove the likelihood of a negative market events impacting the ability to get sufficient cash from the portfolio. Behavioral finance refers to this as mental accounting; corporate finance refers to this as cash flow planning. Having buckets or pools of money (a mental accounting concept) can be a nice and simple way to think of covering your expenses over various periods such as less than a year, one to three years, and over three years.

General financial planning principles suggest holding six to twelve months in cash to make sure that you have sufficient cash to cover those expenses. If you anticipate expenses in the next one to three years, you can use short-term bonds or certificates of deposit to make sure that the money will be known and available. By holding funds in various buckets, you can designate shorter-term bonds or low-risk bond funds to cover expenses and sell them when you get closer.

It is important to avoid market timing so that you are not trying to guess how the market or particular stock will do from one day to the next. If you keep enough cash and short-term bonds to cover three years of expenses, you have a smaller reaction to any shorter-term drop in the market. Market movements like those we have seen in the last few weeks have a much lower effect since you can ride them out. Per Bloomberg, the market is up on average for the following four-week and twelve month periods following a weekly decline of 5% in teh S&P 500. If you do not get enough money from stock funds, then you can ride down the valley and back up the other side.

Food for Thought: How would you feel if the money you counted on to cover the house purchase, or other major expense, next year was 20% or 50% less because of another bad market event?

 

 

 

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