Before you can adopt an investment strategy, you should consider setting aside an adequate cash reserve fund. Cash reserves are what you need to have available just in case that proverbial rainy day comes along. Here are Practical Steps and Benefits of a Cash Reserve Fund.
Rainy Day Fund
Unexpected things happened and bills come in much faster than you could ever anticipate. Plan for the rainy day and you will be ready for when it comes. A cash reserve fund is important to maintain so that you are not forced to liquidate some of your investment portfolio to pay for unforeseen expenses.
Remember…these bills will come in; you just do not know when.
If at that time, the stock market was in a decline, it would be an unfortunate time to sell. Conversely, in a Bull Market, you would not want to have to sell and miss this opportunity.
Have your cash reserve fund set aside so that you could access it quickly without disrupting your investment portfolio.
One rule of thumb is to have three to six months of living expenses in your cash reserve fund. As a rule, this one is not too bad. Every Average Joe will need to refine this to their own personal financial situation.
The number of months of living expenses that you need to maintain in your cash reserve fund is how secure you feel about your income. If your primary source of income is from you and your spouse working and you believe your jobs are secure, then you may be able to maintain a smaller reserve. Couples in this position may be able to get by with three months of cash reserves.
Think long and hard about what your personal definition of job security is. In January, the Federal Government offered a buyout to its employees.
Federal Government jobs used to be the most secure jobs!
Additionally, the COVID-19 pandemic introduced the work from home model (WFH). This is now slowly evolving into the return to office model (RTO). This has not gone smoothly for all employers. Again, carefully consider your specific job situation and how secure you feel and May The Odds Be Ever In Your Favor.
On the other hand, if you are self-employed in a cyclical business and the sole economic supporter of your family, you should consider having the six months in reserve. Remember to consider those living expenses that you may not have every month, such as property taxes and insurance premiums.
No matter what the recommendations are, you need to have something in reserve. Your ‘why’ behind funding your cash reserve is simple:
You will need these funds one day.
Figure out ‘how’ you can start planning for that day now. Do not beat yourself up if you do not have six months in reserve. Just start where you are today. Always keep in mind, 4 Things Every Investor Can Control.
Another consideration is short-term disability insurance. If you were to become disabled, this policy will pay you a certain amount for between three and six months. This may be between 50%-60% of your compensation. If your employer does not offer it and you do not have it, you should consider having the six months in reserve.
Preservation and Accessibility
The next step is to fund your cash reserves. These funds are not invested in the traditional sense. Your primary objectives should be preservation of principal and having funds that are liquid.
Preservation of principal means that whatever money you put into your fund, you are expecting to get all of it back when you need it. You want to be confident that all the money you have set aside will be available when you need to access it.
For example, assume your cash reserve fund requirements are $20,000. However, you invest this amount into a single stock that declines in value to $15,000. Putting your entire cash reserve fund into a single stock certainly would not meet the objective of preservation of principal.
Having liquid funds means you can access your money quickly. For example, if your funds were invested in a Certificate of Deposit (CD), you might have to pay an early withdrawal penalty if you need the funds. This certainly would not provide the type of liquidity that you need.
Traditionally, most investors have used a money market fund for their cash reserve fund. This is because it meets both the preservation of principal and having liquid funds objectives.
Right now, using a money market for your cash reserve fund is appropriate. Interest rates will vary; right now, however, you can get about 4% on a money market fund. This is up significantly from just a few years ago.
Some investors have used a short-term bond fund for their cash reserve fund. Caution needs to be exercised here. If you were to consider this, look for a short-term bond mutual fund with a short effective maturity that invests in investment grade issues. The average effective maturity is somewhere between two and four years. When a mutual fund invests in investment grade issues, the fund owns the highest quality bonds.
Bonds are rated by various rating agencies. Investment grade is the highest rating given to a bond. Owning a mutual fund that invests in investment grade bonds and has a short effective maturity potentially offers two benefits.
First, investing in investment grade bond helps protect against risks of default on the bonds in the portfolio. Second, owning a fund with a short effective maturity will help minimize, although not eliminate, the reduction in Net Asset Value (NAV) if interest rates were to rise.
Clearly there is risk with this approach, a mutual funds NAV is subject to fluctuation. Given the current interest rate environment, this does not appear to be a prudent risk. Keep in mind what you are trying to accomplish – pay for emergency, unforeseen expenses over a brief time.
Unfortunately, it may not be practical for some people to maintain six months of living expenses in their cash reserve fund. I understand. For those in this situation, in addition to what you do have in your reserve, you need to consider other strategies when cash is needed quickly.
For example, you could use a credit card. Granted, you will have to pay extremely high interest on any balance you do not pay off. The average credit card interest rate now is over 24%. 1)
Throw Me a Line
Alternately, if you own a home and have equity in it, establish a home equity line of credit (HELOC) that you can access. You can use this to pay any unexpected bills instead of using your credit cards.
A HELOC offers a big advantage over credit cards. A HELOC should have a lower interest rate than a credit card. Interest rates will vary, currently rates on HELOC’s are between 7%-10% now. 2) That is less than half, or more, of the credit card rate.
Be very cautious here. I am not advocating that you incur any unnecessary additional debt. Now it appears some people are treating their house like an ATM. Whatever you want or need, just buy it, finance it with your HELOC and worry about paying for it tomorrow. There are problems with this. The first problem is:
There is always a tomorrow.
This debt will need to be repaid someday. Have you considered when you are going to pay back this debt? Please, do not say you are going to pay it back when you sell your house. I have heard this answer many times than I would care to admit. Figure out how you are going to pay back this debt before you incur it.
Another problem with HELOC’s is that they are typically written with variable interest rates. If interest rates were to rise, HELOC rates will also rise and the cost of servicing this debt will increase. If you are concerned with rising interest rates, see if your lender offers a fixed rate option.
Action Item
If possible, you should try to maintain at least two months of living expenses in a cash reserve fund. Having access to a credit card or, preferably, a HELOC is a good combination to address any remaining cash reserve requirements.
If you need help with your Practical Steps and Benefits of a Cash Reserve Fund, give us a call at (860) 645-1515 or e-mail Thomas.scanlon@raymondjames.com.
This is original content prepared by Manchester, CT Financial Advisor, Thomas F. Scanlon, CFP®, CPA.
1) Investopedia – March 7, 2025
2) Bankrate.com – February 11, 2025
The information contained in this report does not purport to be a complete description of the securities, markets or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the forgoing material is accurate or complete. Any opinions are those of Thomas F. Scanlon, CFP®, CPA, and not those necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice.
Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices rise.