One of the insights associated with Keynes is the view that money acts as a weapon against uncertainty. If we knew in advance what all future scenarios are, and their associated probabilities, we would not need to hold money. However, the future is uncertain, and so we hold money as a way of reducing the risks associated with that uncertainty. In this article, I discuss how money and cash should be thought about in personal finances, in light of these insights.
This article follows on from the previous, where I discussed uncertainty and how it is different from randomness. The example given there was fairly removed from day-to-day experience. I will now give a more common example.
We recently discovered that we needed a fairly unusual tool – a thermometer used for calibrating oven temperatures. I previously was unaware of the existence of such an instrument, so there was no way I could have assigned a probability for needing it. In a hypothetical world of barter, there would have been no easy way to hedge the risk of needing it, other than stockpiling in my house all the obscure tools that I could possibly need. However, in the world that we live in, all I need to do is have some extra money on hand. Since we live in a world where money is used to settle transactions, money can be used to deal with unknown needs.
Within mainstream economic models, both modern and classic, money is somewhat of a mystery. The theory is based around optimising agents, and the optimal solution would invariably be that one should hold no money. Keynes argued that uncertainty drove the demand for money, and adjusted the function for the demand for money accordingly.
With that background, I will now discuss how I think individuals should view cash (which is a broader than money) within their personal finances. (There is a follow up article that discusses cash holdings within a portfolio strategy.)
Modern Economic And Financial Theory
According to modern economic and financial thought, the rational way of organising your finances is that you should plan out all of your future income sources, project prices for goods you want to purchase, and then optimise your lifetime expenditure plans based on those inputs. And if you plan on leaving an inheritance, you need to plan out the expenditures of your descendants as well.
If this sounds somewhat hard to figure out, that should not be a surprise. Despite their mathematical sophistication, heroic simplifying assumptions, and access to abundant computing power (as well as underpaid grad students), economics professors cannot solve the problem either. This makes this analysis technique useless for both macroeconomic forecasting as well as analysing personal finances.
The reality is that it makes no sense to attempt to optimise every single transaction that we will make. We are stuck with using rules of thumb to handle our personal finances. However, the lesson to be drawn from this mistaken approach is that we should think of our overall financial situation, and not compartmentalise our thinking. Our rules of thumb for how we spend should not be incoherent with our rules of thumb for how we manage our portfolios.
I will now discuss various rules of thumb regarding cash management, which is one area where we need to be particularly mindful of incoherence. Since some of these rules of thumb contradict each other, we have to think about what we are trying to do as we apply them.
What Qualifies As Cash?
Cash can be viewed as the short maturity part of the bond curve. As such, what I write here about cash can be largely extended to short-maturity bonds. However, for personal portfolios, there are big differences in terms of bookkeeping, as bonds can generate capital gains and losses, whereas many cash instruments are treated as only generating interest.
Examples of cash are bank deposits, high interest savings accounts, money market mutual funds. Possibly even some bank term deposits could be viewed as emergency cash if they can be cashed in with a minimal penalty. You could also consider short-term government bond funds as being cash, but they will generate more bookkeeping chores if you enter and exit them repeatedly.
Rule Of Thumb: You Need x Months Of Cash As A Reserve
One of the rules of thumb I have seen is that you should have a cash reserve of a certain number of months of expenses. I have seen suggestions from two months to six months of expenses. The usual suggestion is that you should amass this cash reserve before you start investing (or paying down debt). With this reserve in place, you could cope with some adversity. For example, if you lost your job, you would have some time to launch a job search without having to take any other actions to cut expenses or raise cash.
I endorse this rule, but I cannot specify a particular number of months. It is very situation-dependent.
As a somewhat extreme example of how situations can be different, I left home to do study overseas. I had a Canadian two-year scholarship to cover living expenses; however, the programme was a minimum of three years (and often four). Additionally, I did not have the right to work to get extra money. As a result, I had two years of expenses sitting in cash for most of my time there. It would have been crazy to have blindly apply a rule and invest everything beyond a couple of month’s expenses in the stock market, as I could not afford any investment losses in that situation.
Rule Of Thumb: Who Needs A Cash Reserve – Use Credit
A contradictory rule of thumb is not to have a cash reserve; use something like a line of credit to meet liquidity needs.
This is certainly a more efficient use of resources; you are not tying up financial resources holding cash. In fact, credit lines are an integral part of cash management for businesses. However, businesses have legal teams crafting the terms of their credit lines, and so they should have a good idea of their availability. As a consumer, it is possible that your line could be pulled at the wrong time (i.e., when you really need it). As such, you will still need a liquid portfolio backing up the credit line.
Rule Of Thumb: Who Needs Cash; Financial Assets Are Liquid
Another contradictory rule of thumb is the observation that you can easily sell financial assets. This reduces the needed size of the cash reserve; you just dip into your securities holdings if you need liquidity.
This is a fairly reasonable observation. As such, someone with an investment account should not need to hold as much as six months of cash outside the portfolio. This is particularly true if your portfolio has a "cash" component as part of your portfolio allocation. However, it would be ridiculous to cut your cash levels so tight that it means that you have to call your broker every time you want to go out for pizza.
However, the key word is “liquid”. If your investments are in things like real estate rentals, you will need to have a good liquidity buffer to handle things like repairs or vacant rental units, on top of your personal liquidity needs. You are effectively operating a business, and you will need to plan out your liquidity management like a business. The uncertainty associated with your "business" is added on top of the uncertainty associated with your personal expenses.
NOTE: I discuss the role of cash within portfolios in this follow up article.
(c) Brian Romanchuk 2013