I run into many people who wonder how much cash they should have in the bank. It’s not uncommon to work with good savers and high-net-worth clients who discover they have about 2-3X more than they need in the bank!
Many people don’t realize that holding too much cash in the bank (i.e., checking, savings, money market accounts, and CDs) for longer periods of time gives inflation the opportunity to erode their purchasing power.
In fact, the inflation rate posted earlier this year could cut your purchasing power in half in just 8 ½ years! In this post, we explore how inflation can erode your purchasing power, options you might consider to combat inflation and preserve your purchasing power, and how much cash you should have in the bank.
Instead of dissecting the definition of inflation, which could put you to sleep, let’s look at a real-life situation:
How inflation can erode your purchasing power
Consider this hypothetical scenario. Joe and Elizabeth couldn’t get on the same page about what they wanted to do with a large cushion of cash ($100,000) they had built up in their savings account. They originally had that cash set aside for a Rivian electric SUV that could haul their large family around to an endless number of baseball, soccer, and swimming events for their four children, that range from 5-13 years old.
Elizabeth and Joe had some friendly banter back and forth as they shared their beliefs about how their money should be used and looked to me for guidance. They both had some excellent points!
Elizabeth wanted to “put the money to work” and invest it since they didn’t need it for seven years, and she didn’t want all of their savings sitting in an account earning less than inflation. She felt that leaving money in the bank was foolish because she had seen her diversified stock portfolio double over the last 20 years. She argued that their $100,000 could eventually double, and they’d have enough money to pay cash for the vehicle and have an extra $50,000 to put towards their other goals (home relocation, early retirement, or helping the kids pay for a couple of years of college).
Joe wanted to keep it in the bank, which was paying .5% in interest. He felt comfortable with having money in the bank because it was “safe.” After all, it was FDIC insured and couldn’t decline in value. Joe didn’t want to invest the money in stocks because he knew that stocks could lose money if the market went through a challenging time. Joe was concerned about the stock market risk since stocks can be wildly unpredictable over the short term. For example, the 2007-2009 bear market saw a drop in the S&P 500 of 57%!
Elizabeth’s argued they didn’t need this money for a long time and that markets typically come back within 2-3 years after a recession. Her biggest concern was that their $100k (if left in a savings account earning less than inflation) wouldn’t be enough to pay cash for a new Rivian in seven years. She was concerned about inflation eroding their purchasing power over time.
Did you know the annual inflation rate posted in March would cut someone’s purchasing power in half in about 8.5 years? If that inflation rate continued, a Rivian costing $100k could cost $200k in just 8.5 years.
A more realistic and still conservative scenario for Joe and Elizabeth over the next seven years could be a 4% inflation. At this rate, a Rivian costing $100k would cost a whopping $132,000 in seven years!
Of course, I don’t take sides (because I don’t want to get fired). But I did rely on our company’s core value of “Embrace the Evidence” to educate them on the risks and potential payoffs of four different hypothetical strategies:
Strategy #1: A savings account paying .5%
Strategy #2: A 3-year CD paying 1.62% that could be renewed at the same interest rate after three years
Strategy #3: A conservative investment strategy that holds 20% in well-diversified stocks and 80% in fixed income (i.e., bonds)
Strategy #4: A 100% diversified stock portfolio
All strategies were focused on the same goal – to have $132,000 for a vehicle in 7 years.
For the investment strategies, we used historical data (from 1985 – 2021) to explore the average and worst returns an investor could have experienced over a 1-year and 3-year time horizon (Source: Dimensional US Matrix Book 2022)
(Source: Dimensional US Matrix Book 2022)
Finally, we reviewed some additional considerations that could impact their ability to achieve their goals:
- FDIC insurance – FDIC deposit insurance usually covers checking and savings accounts, money market deposit accounts (MMDA), and CDs from losing value. The standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership category. FDIC insurance does not protect the account holder from losing purchasing power due to inflation.
- Historical returns – We looked at the average and worst one and 3-year returns on these hypothetical investment strategies. Joe and Elizabeth wanted to explore the potential downsides of the investment strategies over a 3-year time horizon just in case they found a good deal in 3 years (which was the soonest they saw needing their money).
- Penalties for early withdrawal – CDs often have stiff penalties for early withdrawal.
- Tax treatment – Interest earned on CDs and savings accounts are subject to income taxes which could be as high as 40% or more if you’re in a high tax bracket and pay state taxes in a state like MN, which are as high as 9.85%. To illustrate an example, let’s assume you had $100k in a savings account or a CD that earned 2% and that you were in the 40% tax bracket. Here’s how you calculated your after-tax earnings:
$2,000 of interest ($100k X 2%)
-$ 800 of taxes ($2,000 * 40% tax rate)
$1,200 in after-tax earnings (i.e. 1.2% after-tax earnings)
Investment accounts can potentially be eligible for tax-free income if an investor holds municipal bonds. Investment accounts could also be subject to much lower taxes on long-term capital gains (typically 0-20% for incomes between $0 and $517k).
Looking at the interest rate you can earn with any savings and investment strategy is essential. But, the number that really matters is your after-tax earnings and how much you can keep after you pay Uncle Sam his share in taxes.
The results of our analysis are below:
Investment strategies for $100,000 vehicle purchase
Time horizon = 7 years, but it could be three years if a good deal arises
Inflation rate = 4%
Options to Combat Inflation
*Hypothetical illustration for information purposes only.
Neither Joe nor Elizabeth liked the scenarios where the CD and savings options wouldn’t cover the cost of the Rivian that they could have bought today. They didn’t want to take out a loan to cover the difference. After reviewing the potential downside of the all-stock portfolio, Elizabeth agreed that a 100% stock portfolio was too aggressive for mid-term investment. So, they settled on the conservative investment strategy. Both were comfortable with the worst one-year return (only down 11.45%) and 3-year return (positive .4%) since they had an adequate emergency reserve in a different account and didn’t anticipate using the funds for another ten years.
Hopefully, this story gets you thinking about how you can protect your purchasing power.
How much cash should you have in the bank?
How much cash you should have in the bank depends on a variety of factors, such as:
- What’s your tolerance for inflation risk?
- What’s your tolerance for different types of investment strategies?
- How much do you need to earn (on your accounts) for your plan to succeed?
If you are worried or wonder what the best use of your short-term cash is or how it should be invested to achieve your goals, click here to schedule a 90-minute, no-cost consultation.
Disclaimer:
All content is for information purposes only. It is not intended to provide any tax or legal advice or provide the basis for any financial decisions. Nor is it intended to be a projection of current or future performance or indication or future results. The information provided is not based on actual current or past clients. All situations are unique, and results will differ depending on individual situation. All information and ideas should be discussed in detail with your individual advisor prior to implementation. All investing involves risk including loss of principal. Past performance does not guarantee future results.