How Much Money Should I Keep in Savings


 

 

First, a hearty congratulations to you.

If you’re looking to build your savings, you’re already ahead of 61 percent of Americans who don’t even have enough savings to cover $1,000.

However, while squirreling money away for savings is generally a good idea, it’s still a balancing act.

Putting too much money toward savings could put you at risk for “cash drag.” Due to inflation, the purchasing power of your savings will diminish over time. The $10,000 you save today will not be the same $10,000 ten years from now.

However, putting too much of your money into stocks and similar investments could expose you to market fluctuations. It will also limit your liquidity, which determines how much cash you have to seize once-in-a-lifetime opportunities.

So how do you determine how much money to put towards savings?

As with most important things, it depends.

In this article, we’ll review an easy framework for deciding how much money you should keep in your savings account, regardless of your current income or financial circumstances.

Emergency funds are useful because they provide peace of mind.

Emergency Fund or Dry Powder?

The amount of money you decide to put into savings will depend on the type of savings account. Generally, savvy investors hold at least two types of savings: an emergency fund and dry powder.

Emergency Fund

An emergency fund is just that: a savings account that is dedicated to emergencies. These include a job loss, medical urgency, or unexpected car troubles.

Emergency funds are useful because they provide peace of mind.

For example, let’s take a look at Sarah and Joel, two (hypothetical) employees that have just been laid off from their beloved jobs. Sarah has $30,000 in savings and Joel has $2,000.

Although the job loss is shocking for both Sarah and Joel, their unemployment experience is much different.

While Joel frantically searches for any job to replace his income, Sarah takes her time searching for the right job. She can rest easy knowing that she has enough money to weather out the storm.

Likewise, with a sizable emergency fund, you can also rest assured that you have the financial resources to endure any calamity.

In addition to providing peace of mind, emergency funds are also useful because they prevent terrible decisions.

With an emergency fund, you will be far less likely to take on bad debt. If mishandled, bad debt – like high-interest credit cards – will negatively impact your wealth.

And if the stock market crashes tomorrow, you can relax knowing a portion of your wealth rests unscathed within your emergency fund. While rash investors panic and sell their stocks at a loss, you will be protected against the natural ebbs and flows of the market.

 

 

Dry Powder

A dry powder fund is a savings account that is dedicated to seizing new opportunities.

The term is borrowed from the 17th century, when military battles were won with cannons and muskets. If a militia’s gunpowder was found to be moist, their entire artillery would be useless. With this in mind, military units kept large reserves of dry powder on hand to stay prepared for battle.

Likewise, you will also need ‘dry powder’ to seize an opportunity.

For example, let’s take a look at Mateo and Grace, two young professionals who are looking to grow their assets during the turbulent 2009 recession. Mateo has $50,000 in dry powder and Grace has $1,000.

A mutual friend suggests to Mateo and Grace that they should consider buying stock in Netflix. Because Mateo and Grace are both fans of the (then) DVD service, they agree that this is a good idea. And, at $5.16 per share, they believe this to be a very good deal.

Grace doesn’t want to spend too much of her dry powder on only one stock, so she only uses 5% of her savings – a total of $50 - to buy stock in Netflix. She buys a total of nine shares.

Mateo also prefers to remain conservative. He, too, dedicates 5% of his savings – a total of $2,500 – to buying Netflix stock. This translates to a total of 484 shares.

By dedicating a portion of your savings to dry powder, you will be in a much better position to seize once-in-a-lifetime opportunities.

Fast forward nine years and Netflix’s stock has soared to $360.57 per share. Mateo’s former $2,500 is now worth $174,515.88. Meanwhile, Grace’s former $50 is now worth only $3,245.13.

Although Grace was still able to capitalize on Netflix’s success – her Netflix stock increased by 6390.26% after all - her total returns were limited because of her initial resources. Because Mateo had far more cash in reserves, he was able to realize a much larger return than Grace.

By dedicating a portion of your savings to dry powder, you will be in a much better position to seize once-in-a-lifetime opportunities.

Keep Your Accounts Separate

Regardless of which type of savings you allocate money to, it’s important to keep your accounts separate. Meaning, your day-to-day checking account should remain independent of your savings, but your various savings accounts should also remain independent of each other.

Separating your checking from your savings will prevent any temptation to splurge your hard-earned nest egg. Likewise, you don’t want to accidentally spend your emergency fund in a risky stock market.

Minimize confusion and risk by keeping all of your accounts separate.

 

 

Allocating Money to Your Emergency Fund

You should have at least six months’ to a year’s worth of expenses in your emergency fund. If you are self-employed or work in a cyclical industry – like the construction and airline industries – consider saving up to double of this amount.

Be sure to also keep your savings in an actual savings account.

For example, a 401K is not a good savings vehicle. In the case of an emergency, withdrawing money from your 401K before you reach eligibility will result in immediate penalties and taxes.

Instead of paying extra money to the IRS unnecessarily, keep your emergency fund liquid and store it within a proper savings account.

When choosing where to store your emergency fund, consider using an online bank. Because these “branchless” banks have lower overhead costs than traditional brick-and-mortar banks, they generally provide higher interest yields to their customers. This means more money for you in the long-run. If the online bank is FDIC insured, each account will be protected for up to $250,000 per depositor.

Once you reach your target savings goal, be sure to also add extra cash each year. This way, you will prevent inflation from eroding your emergency fund’s value.

Allocating Money to Dry Powder

Unfortunately, there isn’t a one-size-fits-all approach to determining how much money you should allocate to dry powder. This ultimately depends on your own financial goals.

Unlike your emergency fund, however, feel free to keep your dry powder in cash equivalents, like money-market accounts, money market funds, or short-term CDs. This way, you will be able to enjoy high liquidity while also capitalizing on market returns.

Don’t Forget to Invest the Excess

While it’s important to keep a substantial amount of savings for emergencies and opportunities, don’t forget your long-term financial goals.

Savings provide risk-free liquidity, but without risk you will miss the opportunity to gain high financial returns. Determine how much risk you can tolerate, then invest the excess so your wealth can multiply.

Build Your Wealth with Axos BankTM

Are you ready to start building your savings? Axos BankTM is here to help.

As a 100% digital bank, our operation costs are lower than traditional banks. This means better interest yields for you and more money for your savings account.

Our High-Yield Savings and High-Yield Money Market accounts earn far higher interest than the average traditional bank.

Don’t waste your hard-earned savings on paying for your bank’s electricity bills. Get started with our revolutionary savings accounts today.