If you’re sitting on cash in savings right now, wondering whether keeping it there is the right thing to do, you’re not alone. When the Federal Reserve Board (The Fed) started dropping interest rates last fall, thus reducing the yields on high-yield savings accounts and money market accounts, consumers with liquid funds began looking for proper next steps.
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Callie Cox, chief market strategist for Ritholtz Wealth Management, pointed out that the past few years of rising rates “led to really attractive reasons to save cash.” However, with rates dropping, it’s time to rethink your savings strategies.
Cox explained the best ways to make your money work for you.
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Keep Saving — With a Caveat
If you’re saving money, this is a good thing, Cox said, and you’re doing better than the majority of Americans. However, by saving money in traditional accounts, “You could be missing out on some greater returns elsewhere, especially if you’re an accumulator,” she said.
“If you’re a younger household and you’re stashing cash away to build wealth, not necessarily for short-term purchases or for a rainy day, then over the past decade it’s usually made sense to just save enough, but not too much.”
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Determine Your Right Level of Cash
Cox explained that in a lower interest rate environment, it’s important to determine your “right level of cash” because “the pros and cons of holding cash have changed as rates have changed.”
She said it’s likely that rates will keep going down more than they’ll go up over the next year, so investors should be proactive with their cash and their savings.
First of all, Cox recommended people look clearly at how much cash they actually need to have on hand right now, “the cash level that’ll allow you to sleep at night,” and to ask how much is too much. “What amount of cash is a little, what amount of cash are you just holding because it feels good?”
If you’re honest with yourself and your goals, you can determine what you need or want, she said. “I think now is the time to be smart about where you put it because there are a bunch of different ways to lock in these high rates,” she said.
Consider the Savings Rate vs. the Stock Market
At current rates, cash is earning between 4% and 5%, but that may not last, Cox said. And even if it does, when you compare that to the average annual return for the stock market, which is riskier but has better returns, by choosing savings over stocks, “Then you’re possibly giving up what is an average 8% annual return for the S&P 500 over long periods of time,” Cox said.
Moreover, that interest rate compounds over time too, Cox pointed out. She said not a lot of people realize that while it’s only a 3% difference between savings and investing in the stock market, over 10 or 15 years “that 3% becomes awfully significant.”
In a nutshell, Cox understands “this almost obsession with cash” based on 5% rates of returns, but she makes an important point that, “The S&P has been up 30% over a 12 month period. While 5% is great, it actually hurts if you miss that 30%,” she said.
Consider Your Age and Risk Tolerance
Younger people in their higher-earning years have a bit more flexibility to take greater risks with their cash by investing in things that also deliver a greater return.
While people tend to worry about the risk of buying stocks too high, particularly if there is a market crash, for fear of losing half of their portfolio, Cox said, “I think the bigger risk that more people need to be talking about is sitting out of the market and missing bull markets that last an average of five years and on average have delivered about 30% annual gains.”
For people who are closer to retirement and have a shorter time horizon to stay invested, Cox still believes it’s worth investing your money over straight savings, though you may tone down the risk factor.
Considering that the average lifespan is 80 years old, she pointed out that even in your 50s or 60s, you may have between 20 and 30 years of investment time to utilize.
“The benefits of taking risks don’t magically disappear when you’re middle-aged or you hit your retirement age,” she said. However you might shift to things like bonds or CDs.
“If you are on the older end, nearing retirement, it’s important to evaluate your cash holdings and understand exactly what you need and what you can invest to ultimately pull you through the rest of your life. Because in retirement, your main income isn’t your job anymore, it’s your portfolio.”
Keep Emergency Funds Liquid
The one clear exception to saving cash is your emergency funds, Cox said. “Emergency funds need to be in cash. The whole point of emergency funds is being able to access them when you need them the most. So it’s important to trust that wherever you’re putting that cash will be there if you need to tap it.”
For those funds, she said, “You can’t always trust the stock market.”
While the typical recommendation is to save three to six months’ worth of expenses, she suggested that up to a year’s worth isn’t a bad idea if it’s feasible.
“Some people may not feel comfortable with only having three months of expenses, depending on your own risk tolerance, whether you’re self-employed, or employed in a job that’s more or less braced for economic ups and downs.”
In general, if you’re in a position to have extra cash to squirrel away, consider the best vehicle for the returns you want and your future goals and keep only what you need in savings accounts.
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This article originally appeared on GOBankingRates.com: 5 Things You Should Do With Extra Cash From Your Paycheck
