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Q: I am a 28-year-old professional and I’ve finally been able to start saving each month. Where should I invest my money?
A: That’s the million-dollar question! While investing can grow your wealth, and ultimately help you reach your financial goals, many young professionals are under the impression that their first dollar of savings should be immediately deployed into the market.
However, what many young people are unaware of is a very important financial planning concept: the cash reserve.
A cash reserve is generally defined as three to six months of living expenses positioned in cash or cash equivalents, such as checking and savings accounts, money market funds and CDs.
It is designed to help you deal both with emergencies and opportunities so that you don’t disturb long-term financial assets, such as your retirement savings or accumulate consumer debt.
While I admit that establishing a cash reserve may not be as sexy as investing in stocks, the concept should not be ignored. I have witnessed many successful young professionals make the mistake of investing their surplus cash and annual bonuses before first building a cash reserve.
Glancing back at 2008 illustrates just how dangerous this misstep can be. For example, assume that your only investment, outside of any retirement accounts, was $25,000 in an S&P 500 index fund. In this scenario you could have lost close to 50% of your investment’s value.
If you lost your job, like so many did at the time, your most readily available source of money – the $25,000 investment – was just cut in half. If you were living a lifestyle of $5,000 per month, you would have lost three months living expenses, which could be devastating.
Yet, had you kept the $25,000 as a reserve, you would have given yourself at least six months to get back on track, which could be the difference between staying afloat or sinking in the water.
Being in a position to build a cash reserve implies that you have already established solid discipline and control around your expenses.
It also implies that if you have employer-matching 401(k) contributions at your current job, and you have elected to contribute an amount that would capture at least the match being offered.
The bottom line is that establishing a cash reserve provides yourself with certainty and peace of mind in an uncertain world.
It is also a straightforward and an easy-to-understand concept if you are still figuring out your long-term financial goals.
So before you consider investing that cash, consider the importance of a cash reserve and plan accordingly.
Boneparth is a certified financial planner and COO of New York-based financial services firm Life and Wealth Planning. Twitter: @dougboneparth
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