The economic landscape has been a battle ground between the proverbial bull and bear this entire year. Sometimes the stock market rallies. Sometimes there is red across the board. It seems like the entire market has traded on trade war tensions and tweets this entire year. Furthermore, it has been over ten years since a real correction – despite the dip at the end of 2018. With that being said, how much cash should you have during an economic downturn?
The amount of cash in your coffers during a downturn is more of a subjective thought experiment rather than an objective one. Should you have 20% of your assets in cash? Maybe. Or maybe you should have 50%? Or should you have 100% in cash? Seems extreme, but in some circumstances it may work.
To answer this question intelligently we should first describe what a recession might mean for you. I have come up with a list of bullet points that describe a typical recession (feel free to add additional points in the comment section below):
- Loss of a job or a reduction in your income
- Low opportunities for salary growth or career advancement
- Continual payments of your fixed costs (rent, utilities, car, credit card, etc.)
- Reduction in asset values (401k, IRA, Roth, individual stock holdings, etc.)
- Taking a less prestigious job to pay the bills
The most important bullet point is loss of a job or a reduction in your income. Losing your job is scary. I know from secondhand experience. Back when my wife and I were still grinding it out in college, my wife lost her job unexpectedly.
My wife (girlfriend) at the time were not wealthy or even high-income earners at the time. I think we probably made $20,000 all in that year. Our fixed costs were low but relatively still high for us. And when my girlfriend came home that night and told me she lost her job it was a scary situation.
We both went through our finances that night. My job wasn’t enough to pay for all our expenses. But we did have something like $2,000 saved up. This was enough money to last three months (thank God for roommates). Thankfully, it only took a week for my girlfriend to find a new job.
The economic environment was not bad when my wife lost her job. Unemployment was around 4%. Employers were dying for help. You could apply for a job and the next day get called in for an interview. This made it easy for her to find a job. It won’t be easy to find a job during a recession.
When a recession hits (and it will) people will lose their jobs. Unemployment will increase (see chart below). Resumes will flood employers. You may even lose your â€˜comfy’ job.
Source: Macro Trends – Unemployment
Think about what you would do if you lose your job. How long would you last without income? How would you fund your expenses? How long do you think it would take for you to find another job? Did you realize that fixed costs (rent/mortgage, bills, etc.) will stay the same if your income drops? Your financial profile will deleverage quickly.
According to Money.com, the job search process takes on average 43 days. A survey on Monster.com says it takes on average 1-2 months for someone to find a job. Finally, according to Randstand, it takes on average 5 months to find a new job.
The thing about these surveys, they were assuming a normal economic environment – not a downward cycle. In a bad downward cycle, it may take up to a year to find a new job.
Building on that narrative, you should have enough cash (and more) to survive a loss of your income for at least six months to a year. Let me repeat that, six months to one year of living expenses saved up.
This may sound daunting, but you will thank me if and when the next recession hits. This cash reserve is the emergency life jacket you will use that will save you and your family during your unemployment. It will ensure that you are not taking money from your investment accounts (which will be down during a recession) or loading up on credit cards to pay the bills.
How do you go about saving up six to twelve months of living expenses? Easy. This is purely a function of your savings rate and your willingness to be frugal.
During a bad downturn, the ones who get hit the worst are the people with the highest cost of living. These are the people who are saving nothing, zip. They spend lavishly. Money goes out the door faster than it comes in. They likely have car payments. Low amounts of equity in their homes. Credit card debt. The whole anti Dave Ramsey hoorah!
When you are saving nothing, and you lose your job your finances and lifestyle will deleverage quick. Have you ever seen the movie The Company Men? Watch it. It is the epitome of what happens when corporate downsizing hits your firm.
Don’t be the guy who is saving nothing. This will end bad. Eating your marshmallow now means you won’t get a second one in the future.
Save your money. Track all of your expenses in Microsoft Excel. Increase your savings rate. Build your cash reserves. Having a lot of cash is a good problem to have. Make having a lot of cash your new problem.
Personally, I have enough cash and investments to survive a downturn. My cost structure is low. I have the ability to cut fixed expenses further if needed. I can deleverage my expense quickly. Given my profession as an investor and handle on my finances, I try to target a certain percentage of my assets in cash.
Right now, 14% of my assets are in cash. This includes cash in my savings account, Traditional IRA and Health Savings Account (HSA). I am looking to grow my cash balance to around 30%. Growing my cash balance to 30% won’t be a function of selling assets but rather a function of saving income.
My wife and I are currently saving over 50% of our income. We are looking to retire early. A high saving rate of 50% will allow us to get to the 30% cash savings in a few months.
If we can get our cash balance to grow organically to 30% in a few months I will feel well prepared to take advantage of cheap asset prices during a recession. When there is blood on the streets you will want to be buying, not selling your assets. I don’t hope or wish for an economic bloodbath, but I want to be ready for when one hits us.
What is your savings rate at? Do you have enough cash saved up to last six months? Do you have enough cash to last one year? Will you be ready when the next recession looms around the corner?