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Too much cash often seems like a good problem to have. However, for young professionals looking to maximize future savings, allowing excess cash to build up without being consistently invested towards a specific goal creates an unnecessary drag on the portfolio’s long term performance.
When a young professional first walks into my office, she may have questions about her 401k or stock options, but when it really comes down to it, her main concern typically involves finding the best use for the cash in her bank account. With each paycheck, money comes into the checking account and the amount that doesn’t go towards paying bills begins to accumulate above the recommended three to six months of emergency spending cash. Sometimes the accumulated cash gets moved to savings, other times it goes towards paying off debt, and far too frequently it just sits there waiting for an opportunity. As a group, millennials hold twice as much cash as boomers and according to a 2014 study by The Brookings Institution, 52% of Millennials have the majority of their money in cash, whereas other generations have 23% of their money in cash.
In the short-term this doesn’t seem like an issue. In fact, too much cash typically seems like a good problem to have. However, over a lifetime, having too much cash can be just as expensive as buying too much insurance or racking up too much debt. To put the numbers in context, if a person were to sit on $10,000 of excess cash for 40 years, earning nothing, rather than investing it and earning 6%, the investor would miss out on $92,857.18 of gains, exclusive of taxes.
Further, the problem of excess emergency cash isn’t limited to those with passive interests in personal finance. Savers that spend their days researching the stock market are often impacted just the same, never finding the perfect time to invest. As I wrote in this article for Investopedia on Automating Your Financial Life:
If the stock market is trending down she thinks, “I’ll wait for it to go lower before getting in.” If it’s going up she thinks, “I’m just going to wait for a pull back before I invest.” This leads to atrophy until one day she gets bored, realizes the cash balance is too high and determines to put excess funds into the first thing that strikes her fancy. That could mean paying down debt, investing, or turning on HGTV and figuring out how she is going to flip properties.
Most investors would be better served by automating the process, or creating a strategy that divides the anticipated savings between cash accounts, retirement accounts, taxable accounts and debt payments and then setting the monthly transfers to each one on autopilot.
To this end, young investors need to set financial goals, determine the appropriate emergency cash reserve, and allocate the excess on a consistent, automatic basis.
This article is from the five-part series on the Most Common Investing Mistakes.
Investing does not have to be complicated but far too often, individuals take risks they don’t understand, trying to outperform a benchmark that has no relevance to their financial goals. This series is focused on simple things savers can do to improve their long-term performance.