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The latest inflation report shows prices rose 7.9% over the last 12 months. That increase is many times higher than what you’re likely earning on cash deposits, which means your emergency fund is costing you money.
In times like these, it’s natural to question your cash savings strategy. Going purely by the numbers, you might consider spending your emergency fund on stocks and other investments with inflation-beating returns. But even in matters of finance, the numbers don’t tell the whole the story.
There’s a bigger picture on the value of your cash to understand — a bigger picture famous investor and CEO Warren Buffett alludes to in his latest letter to Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) shareholders.
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Cash for financial strength
In that letter, Buffett explains Berkshire’s position on cash. Buffett and Berkshire Vice Chairman Charlie Munger use a hefty cash balance to protect the company’s financial strength. Specifically, Berkshire always holds at least $30 billion in cash and cash equivalents. In Buffett’s words: “We want your company to be financially impregnable and never dependent on the kindness of strangers (or even that of friends). Both of us like to sleep soundly, and we want our creditors, insurance claimants and you to do so as well.”
Said another way, the minimum cash balance is a safety measure to keep Berkshire solvent through unforeseen downside scenarios.
Discipline in investing choices
When Buffett wrote the shareholder letter, Berkshire’s cash and cash equivalents balance was $144 billion. That’s more than four times the $30 billion minimum. Why so much cash? Because Berkshire’s leadership team doesn’t invest for the sake of investing. It instead sticks to its investing standards — even when high inflation degrades the spending power of the company’s cash.
Applying Buffett’s cash stance
To apply Buffett’s cash stance to your own finances, there are two questions to ask:
How much cash do you need to avoid tapping credit cards, family and friends, or 401(k) loans for help?
What are your investing standards?
These are tough questions to answer. You can’t predict every scenario that could generate an unbudgeted expense. And you may not have the time or interest in documenting parameters for your investment choices. Fortunately, there is some collective wisdom on these topics that can help.
How much cash is enough?
The general rule on cash is to have enough to pay your living expenses for three to six months. That’s a starting point for a cash savings target, which you can tailor based on your lifestyle. For example:
If you play an extreme sport on the weekends, your emergency fund should cover your health insurance deductible as well as your living expenses.
If you live in a historic home, you might also consider your homeowners insurance deductible.
If your income outlook is uncertain, you might target a higher cash balance — one that would cover, say, eight to 10 months of living expenses.
Setting investment standards
Following Buffett’s strategy, you’d reach your minimum cash balance first, then invest extra funds according to your standards. Your standards don’t have to involve financial ratios or growth hurdles, especially if you’re a new investor. They could be much simpler. For example:
Do you want stocks that are relatively resilient? Look at large companies based in the U.S., such as what you’ll find in the S&P 500.
Do you want dividend income? Look at longtime dividend payers like Dividend Aristocrats.
Would you rather earn through appreciation only to keep your tax bill low? Growth stocks or funds would be suitable.
Would you rather a professional pick quality stocks for you? Research quality-factor exchange-traded funds or find a stock-picking service you trust.
The point is to know what you want before you invest. If you’re not sure, it’s acceptable to hold extra cash temporarily until you figure it out.
The true value of cash
Cash on hand bails you out of emergencies. It protects you from taking out debt with aggressive terms or pulling money from your investments when the timing isn’t right. There is a cost to holding cash — and that cost rises when inflation is high. But in return, you — like Buffett and Munger — can sleep soundly, because you know your financial position is strong.
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Catherine Brock has no position in any of the stocks mentioned. The Motley Fool owns and recommends Berkshire Hathaway (B shares). The Motley Fool recommends the following options: long January 2023 $200 calls on Berkshire Hathaway (B shares), short January 2023 $200 puts on Berkshire Hathaway (B shares), and short January 2023 $265 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.
