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We all know it’s important to save and invest. But let’s get down to details: how much are you supposed to keep in cash?
If you leave too much in cash, you face inflation rate risk. If you invest it all, you may have nothing on hand for emergencies. Here’s how to find the balance:
The main reason not to store all your wealth in cash is inflation. In most developed countries like Singapore, the government will target an inflation rate of three per cent per annum. The exact reason would take several pages to explain, so we’ll summarise by saying three per cent is a healthy amount, which is typical of a growing economy.
This means that the prices of things rise by about three per cent per year. This is why in the 1980s, it was possible to have chicken rice for one dollar, and 30 years before that satay sticks could cost one cent each. As the supply of money in the economy grows, things will get more expensive.
However, your dollar notes do not change to match inflation. This is why, if all your wealth is in cash, it is almost as if you are losing three per cent per annum (or whatever the inflation rate is).
As a rule of thumb, a retirement fund must have returns that beat the rate of inflation by two per cent (i.e. Five per cent returns).
Home values in Singapore have been known to appreciate more than 20 per cent in a single year. Even the simplest insurance policies can generate returns of three to five per cent per annum. The Straits Times Index Fund generates returns as high as eight per cent annualised over 10 years, and many REITs can reach seven per cent.
There are plenty of ways to grow your money faster than just leaving it in the bank, or in a sock. So why not have nothing in cash, and keep it all invested?
The first reason is liquidity and volatility. You may not be able to get the money when you need it, and withdrawing it might create a loss. For example, say you have around S$40,000 worth of shares.
Now say you have a medical emergency, which requires an expensive operation. In order to get money for this, you will need to sell your shares.
But share prices move up and down all the time. What if you have to sell during a market downturn, and get less? Your S$40,000 worth of shares may only be worth S$35,000, at the time when you sell it.
The second reason is opportunity cost. If a good opportunity comes along, like a chance to get a university scholarship for your child at a much lower cost, you might not make use of it if all your money is tied up.
The key is to have a balance between the two – some of your money needs to be within arm’s reach, and some of it needs to be invested.
There are many different ways to work out how much should be kept in cash, and your financial advisor will no doubt vary the guidelines to match your situation (e.g. If you have children to raise, you will need more cash on hand than if you were single).
However, here are four simple basics you can consider:
A common method is to accumulate six months of your income in an emergency fund. This should be sufficient to cope with most emergencies. Once you have this amount, you can start channeling your money into assets such as your house, a mutual fund, an insurance policy, etc.
For example, say you earn S$2,500 a month, after CPF. You can save 20 per cent of this (S$500) until you accumulate S$15,000 (it will take you two and a half years).
After that however, the S$500 you save each month can be redirected into blue chip investment programmes, an insurance policy, or other investments.
Note that if the emergency fund is used, you must have the discipline to top it up again.
This is an alternative to six months of your total income. However, you will have to keep track of your budget.
Using this method, you first need to add together your fixed costs for the month. This involves bills that you absolutely must pay. Examples are fixed rate mortgages, your power bill, and your personal instalment loans.
Next, you need to work out your variable expenses. This can include costs such as food or floating rate mortgages. As a guideline, add 30 per cent on top of the minimum amount (e.g. If the least you expect to spend on food is S$500, budget for S$650).
The total monthly expense is thus your fixed costs + (variable costs + 30 per cent). Multiply this number by six, and it is the amount you need in cash.
As a rule of thumb, people who are 60 to 69 years of age should have at least five per cent of their total assets in cash (e.g. If the total worth of their assets is S$300,000, they should have S$15,000 in cash). Note that by assets, we include the value of their house, minus any outstanding loans on it.
Those in their 70s should keep 10 per cent in cash, and those in their 80s should keep 30 per cent in cash.
This is because at an advanced age, it is not safe to leave money in volatile assets. There is no reason for someone who is 77 years old to take a dangerous bet on the stock market, for example.
This method is a bit lean for our liking, but it is also common. This approach is very similar to point #2.
Calculate your fixed loan repayments first, such as your personal instalment loans. Next, calculate the minimum repayment amounts of your variable loans (on a credit card, for example, this is typically S$50 or five per cent of the outstanding debt). Add them all together, and you have your minimum loan obligations for the month.
Multiply this amount by 12, and that is the amount you should hold on to in cash. This ensures that you can cope with your debts in the event of retrenchment, or a career change.
It takes more discipline to maintain cash reserves than a stock portfolio or a property asset. This is because you are constantly tempted to use the cash, which is in arm’s reach. You should consider measures to dissuade yourself from doing so, such as by locking the bank card for your savings account in a seldom-opened drawer.
This article was contributed by SingSaver.com.sg, Singapore’s #1 personal finance comparison site for credit cards and personal loans.