One big reason people hire financial advisors is because they want to “put their money to work” – that is, invest it profitably rather than just sit on an inert pile of cash. I think that is a very sensible thing to want, obviously… but a pile of cash has its uses too.
As investors, we sometimes think that every spare cent should be “put to work” somewhere in our portfolio. I’m here to tell you that is not true: there are at least two big reasons why you should always allow some of your extra money to be “lazy” and sit around as cash instead.
1: You need cash for confidence
Money may not be able to buy happiness, but there is compelling evidence that it (or at least a certain amount of it) contributes a lot to our psychological health. More than that, however, a couple of recent studies suggest that liquid wealth is particularly important!
The below chart shows the results of one such study: the correlation between participants’ sense of well-being – both financial and in general – and various other factors such as their income, cash savings, age and even relationship status.
The blue bars show each factor’s correlation with overall life satisfaction, while the orange bars show its correlation with financial security. Note that “average monthly liquid wealth” (i.e. cash savings) had the highest correlation with financial security by a long shot. It also leads in overall satisfaction too, albeit by a narrower margin.
Granted, correlation does not prove causation; but I think most people would agree that a decent amount of emergency savings helps with overall peace of mind. And this benefit is not just psychological – it contributes to overall financial success as well. Which brings me to the second reason.
2: You need cash for investing
This may seem obvious at first. Duh, of course you need cash to invest! How else are you going to purchase assets? It goes beyond that, however: you need cash that is not invested if your overall investment strategy is to succeed.
You might be surprised to hear me say that, as one of my favorite talking points is the importance of beating inflation. And of course, plain cash cannot do that.
I stand by that principle, but that does not mean I think holding cash is bad in and of itself. The point, rather, is that you must take risks in order to gain returns – and you cannot take risks without a safety net of available cash to support them.
Well, I suppose you can… but I would not recommend it. If your risk isn’t mitigated by a safety net of short-term savings, then you are far more likely to panic when the market has a bad day. And as we’ve discussed elsewhere, fidgety investors underperform.
In short: risk is stressful, and stressed investors tend to make poor decisions. So by keeping a decent cash reserve on hand, you give yourself the psychological foundation for financial success.