Why having too much cash is a bad thing for your financial future
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Why having too much cash is a bad thing for your financial future

Want to hear some scary financial statistics?

Seventy-eight per cent of US workers today say they live from pay cheque to pay cheque.

You need to make your money work to set up your financial future.

You need to make your money work to set up your financial future.Credit:Sasha Woolley

Only 39 per cent of Americans feel they could cover a $US1000 ($1400) emergency if something happened to them tomorrow.

These numbers indicate that most people probably worry about whether there's enough money in their bank account just to get through the week until they can cash their next cheque.

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If you're not part of that group, that's a good thing – but that may mean you're facing a different kind of problem on the other end of the spectrum.

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Other studies and polls have shown that it might not be 20- and 30-somethings who are facing these financial challenges. Surveys show that millennials actually save more than Gen X and Baby Boomers, and could be on track to retire with more wealth than their parents had.

But can you have too much of a good thing when it comes to money? That's debatable – but specifically, when it comes to cash, the answer is yes.

Do you have too much cash in your bank account?

There is such a thing as too much cash in your bank account. Stashing money away in savings accounts at your local bank or credit union can prove problematic for several reasons.

If you have too much cash in your bank account, you're making it harder to reach your financial goals because your cash isn't working for you. It can't earn the same kind of return that is possible if you invest it wisely according to a strategic plan that aligns with your needs, opportunities, and desired outcomes. Having a cash cushion and emergency fund are key components of a sound financial plan. But if you keep too large a percentage of your assets in a low-interest savings account, you're fighting an uphill battle to build the wealth you need to create the life you want.

You might think your money is safer in a bank than in the market, but you may actually be losing purchasing power because you're not keeping up with inflation. This is closely related to problem 1.

Although interest rates rise and fall over time, the rates can often be very small. And this means that inflation, which has averaged about 3 per cent over time, eats away at the money the longer it sits in the account, reducing your ability to purchase everyday goods and services.

Saving money in cash leaves you exposed to this erosive power

You might believe it's better to wait until you feel good about how the market is performing before jumping into it and investing. In the meantime, you'll just keep your cash in savings.

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But market timing is a dangerous game to play (and heaps of data show investors who try it fail; it's about time in the market, not timing the market). More importantly, you might not be avoiding risk at all. Too much cash in your bank account is also a real risk because of inflation, or the increasing costs of the things you want to buy in your life.

Although you may not physically see your account balance drop, over time that cash will lose value – to the point at which it will be worth less in 30 years than it's worth today, making it that much harder to pay for life's expenses. All investments carry risk. But failing to invest at all carries risk, too.

The solution? Determine how much risk is appropriate for you to take on in order to meet your financial goals. And then understand that there is such a thing as too much cash in your bank account.

Here's how much cash you actually need on hand

Figuring out how much cash you actually need in your bank account is pretty simple.

First, have enough to cover emergencies and unexpected expenses (in other words, keep an emergency reserve). A safe guideline is to keep a minimum of three months' worth of income in a liquid savings account.

If you want a bigger safety net, save between six and 12 months' worth of income in your emergency fund instead. Then, keep a cash cushion to handle irregular, one-time expenses that you can expect, such as yearly premiums, registrations, annual events, and so on.

You can keep this in your an account where it's readily available as those expenses roll around – just be sure to plan for them instead of letting them sneak up on you.

Take the total amount of an irregular or semi-annual expense and divide it by 12. That will give you the monthly amount that should be included as a line item in your monthly budget. Set that money aside and put it towards your cash cushion so it's available whenever that cost comes due.

Finally, you'll want to save the appropriate amount of cash relevant to your short- to mid-term goals. For example, you may not need to have all the money necessary to fund next year's trip in cash right now, but you do need to identify how much you can save over the next year to get there.

And that's pretty much it. Any level of cash over these markers is likely going to be "too much".

Keep in mind that this applies to all your cash across all liquid accounts. Cash is a great place for safety, but safety doesn't help you grow your money. Yes, investments come with risk. But stuffing cash into a mattress isn't the smartest financial plan, and I'd argue that taking that route is as big of a risk as investing. The longer you keep cash in a bank account, the bigger the risk of losing buying power due to inflation. You want to put your money to work for you so you can take advantage of compound returns in your investments and grow significant wealth over time.

Eric Roberge is a certified financial planner and the founder of Beyond Your Hammock. This is an adapted excerpt from his free ebook, Going Beyond Simple Money: Strategies to Grow (and Keep) Real Wealth.

This story first appeared in Business Insider. Read it here or follow BusinessInsider Australia on Facebook.