You can't really begin a successful investing program until you have a good foundation under your feet. For most investors, that means putting some money away in a savings account as an accessible safety net, should you encounter an emergency. But how much money should you keep in your savings account? That depends on several factors, including:
- The stability of your employment situation or another primary source of income
- The level of fixed expenses you incur each month
- Your desired standard of living
- The probability of large demands on your resources, particularly those that might arise on short notice
- The amount of cash you need in order to feel secure, which is an emotional consideration that differs from person to person and even from year to year
It's helpful to take a serious look at these factors if you want to determine the amount of personal savings that makes sense for your situation. You can start with the steps described here.
Be Honest About the Stability of Your Income
Do you have a career with stability (for example, are you a tenured professor or teacher)? Or are you a temporary worker in a seasonal industry that faces boom and bust times?
Even if the incomes in these two scenarios are identical, the latter person would need to have more money in a savings account for adequate protection, since liquidity shocks are more likely.
Another alternative is to follow what might be called the "Berkshire Hathaway business model." Over the course of many years, you can greatly reduce your risk by adding new income streams. Whether you're a nurse who owns an ice cream shop or a geology professor who has built a portfolio of master limited partnerships that bring oil, natural gas, and pipeline profits into your checking account, the more diverse your cash flow, the less you have to rely on a single activity or operation to keep the lights on.
Calculate Your Fixed Expenses
The next step when trying to determine how much money you should keep in a savings account is to look at your fixed expenses. If you were to lose all of your income overnight, how long could you maintain your standard of living? Many experts recommend at least a six-month emergency reserve in your savings account, and others urge you to consider at least one to two years' worth.
It's more ambitious, but you don't have to build that reserve overnight. You can work at it by setting a goal and slowly accumulating your surplus. Another way you can get there is by reducing the cash demands on your family's finances. For example, you might pay off your mortgage earlier than its stated maturity. With no mortgage payment, your emergency fund sitting in a savings account doesn't need to be as large.
If you have credit card debt, you may want to build a smaller emergency fund and then focus on paying off that debt.
Determine Your Standard of Living
You can figure out your desired standard of living by taking account of the necessities and comforts or luxuries in your life. Many necessities will already be on your list of fixed expenses. Comforts or luxuries include expenses like cable or streaming services, movies, concerts, sports games, jewelry, restaurants, and vacations. In other words, anything you don’t absolutely need to live.
Make a list of everything in these two categories, and then try to narrow down the comfort category as much as possible. Consider each item on the list, and ask yourself whether you truly feel that you need it in order to be happy or whether you can do without it, at least for a period of time. Set a reasonable budget for each of the items on the list that you decide to keep.
The Likelihood of Large Demands on Your Cash Reserves
Although unexpected events can always arise to put a large burden on your finances, you can see certain situations coming down the road. Are you facing the threat of a major lawsuit? How's your health? Do you see a potential for significant medical bills? Is your family-owned business suffering a decline in revenue? If so, try to estimate what these events could cost you, and add that amount to your savings goal. One of the worst-case scenarios is that you end up having too much money on hand. If that happens, you can always buy an asset to generate passive income next month or next year.
Ask Yourself What You Need in Order to Feel Secure
This amount differs for everyone, and it may even change based on the phase of your life. How much money, sitting securely in a savings account, would it take for you to sleep well at night? You probably have a figure that comes to mind immediately, even if it is irrational.
For some people, it's $10,000. For others, it's $100,000. Billionaire Warren Buffett likes to keep $20 billion minimum around, though he parks it in Treasury bills, bonds, and notes, not a savings account. Figure your number out by being honest with yourself and considering all of the factors above. Once you hit your goal, you can start putting money into investments with higher returns.