It’s time to answer the question that’s probably burning in your mind at this very moment… How much cash should I carry in my wallet? As it turns out, a lot more goes into that decision than you may think. Read on to find out how the Fed, opportunity cost, and inflation all impact how much cash you should carry in your wallet (and more importantly, hold in your portfolio).
A Necessary Evil
First thing’s first; I hate cash, so I carry it around with me under protest. Whoever said “cash is king” didn’t know what they were talking about.
Credit cards on the other hand are wonderful. They’re convenient, take up minimal space, have built-in theft and fraud protection, and they even pay you money for using them (2-5% cash back on my two primary cards!). The only slight problem is that if you don’t pay them off, I’m pretty sure someone comes and takes your firstborn child, and puts you in debtor’s prison for the rest of your life… But those are just minor details, right? Pay off your credit cards every month, and they’re amazing.
Everything that’s good about credit cards is absent from cash. Cash has a ton of problems—you can lose or destroy it, it’s dirty, it has no built-in fraud or theft protection, and it’s a bad holding financially. Essentially, the more cash you have, the poorer you are. That’s because there are huge opportunity costs to holding cash.
I like to think of money as my employees. My portfolio is my own personal company full of little employees. And like any company, some employees are better than others. My cash employees are some of the worst. Instead of working hard to help me make a profit, they sit around all day doing nothing. In fact, they’re so bad that they actually cost me money just to keep them around. I’d be better off if they left MyFiIntheSky, Inc. and went to work for someone else… (Most of the time. Sometimes you need cash—like if you’re buying a house in Los Angeles… But that’s another story.)
You see, every dollar you have invested in the stock market, real estate investments, and other alternative investments, continuously spits off capital gains and/or dividends. But a dollar held in cash doesn’t. To make things worse, each cash dollar you own actually loses value every year. That’s because inflation is constantly chipping away at your net worth, trying to make you poorer.
Inflation and the Federal Reserve.
Inflation in the United States has remained pretty calm over the past few years, but we had some pretty rough years back in the ’70s and ’80 where inflation reached upwards of 13%. That means during a single one of those high-inflation years, $100 held in cash would lose $13 in value. Even under ideal economic conditions, the Federal Reserve still targets about 2% of inflation per year, so you can assume that your cash will probably lose about 2% of its real value, every single year.
Umm, there’s no real reason.
The Federal Reserve (or Fed) is responsible for balancing interest rates and economic growth. So if the economy is stagnant, the Fed may lower interest rates to spur a bit of economic growth. How does this work you ask? A simplified answer is that when the Fed lowers interest rates, it becomes cheaper to borrow money, and companies can use that cheap money to expand operations and hire new employees.
This is a good thing for the economy because it increases growth and decreases unemployment, but it also has a side effect. All those people who now have jobs can go out and buy more stuff. Buying more stuff is actually pretty good for the economy as well, but the extra money that’s injected into the economy causes inflation. When there’s inflation, the dollar becomes slightly less valuable—it can’t buy quite as much stuff because the nominal cost of goods increases slightly.
So the Fed has to balance their goal of stimulating the economy with making sure not to cause too much inflation.
Why have any inflation at all?
You might wonder why the Fed doesn’t target 0% inflation. It’s really just a safety measure. The 2% goal is a number that’s not too high, but it also has some built-in wiggle room. The real danger isn’t high inflation—it’s negative inflation. If inflation drops below 0%, you have a de-valuing currency, and that’s really bad for the economy, so the Fed builds in a safety net by setting a 2% goal. If inflation is a little lower than the target, like it has been for the past few years, everything is still OK.
You didn’t think we’d get to talk about the Fed today, did you? Must be your lucky day.
What Does Inflation Mean For Cash?
OK, now we’re back to cash. We now know that cash, because it’s not earning you money through investment gains, is actually losing you money through inflation. Remember that with 2% inflation, the value of your cash decreases by 2% every year on average, which really doesn’t sound like that much…
But you know how much I love compound interest… Over a few years, those compounding 2% losses add up. To have the equivalent buying power of $1 back in 1950, you’d need over $10 in 2017!
Let me illustrate this further. We’ve all heard stories from our parents and grandparents about how they bought their first house for some ridiculously low amount—probably a few thousand dollars. If you’re like me, and especially if you live in an expensive area like Los Angeles, you’re very jealous. You should be because now those same houses are worth hundreds of thousands of dollars. This graph shows the average price of houses from 1965 to 2015, and look at how it has sky rocketed!
Is that just because houses are really great investments? Not really. In fact, the real price of a house really hasn’t changed all that much. Houses are a great hedge against inflation, but are actually a pretty bad investment.
The following graph shows an index of housing prices, adjusted for inflation. In other words, this next graph shows the “real” price of houses. See how the graph above has a nice upward direction over time? The next graph stays pretty flat overall. It shows that every $100 spent on a house in 1900 would have become around $140 by 2000, adjusted for inflation.
It’s nice to see some positive return on a house purchase, but this graph shows a real increase of only 40% on average over 100 years—about a 0.35% compounded yearly return—where the stock market has returned about 6-7% per year, adjusted for inflation, over that same period. So those huge increases in housing prices are really just the power of inflation working, not houses becoming more valuable relative to other items.
At least the house kept up with inflation (and beat it by a little bit). If someone had stashed away a few thousand dollars in cash in 1900 instead of buying a house, that cash would still only be worth its face value today, while the house that they chose not to buy would probably now cost hundreds of thousands of dollars because of inflation.
Get On With It Already!
I’m sorry, sometimes I can’t help myself from rambling… And how could I pass up the chance to talk about the Fed, inflation, and what a terrible investment houses are? Obviously I couldn’t.
But let’s get back on topic. Now that we know how horrible cash is, and how much I hate it, how much of it do I carry in my wallet?
I carry $120 in my wallet. Every day. Here’s why.
I love simplicity, and that carries over into what I carry around every day. I carry a very small wallet that only has room for a few cards and a couple bills folded into thirds.
With my cash system, I only have to carry around one $100 bill, and one $20 bill. Two bills, and I have all of my cash needs taken care of.
I carry $120, which isn’t a tiny amount of money, but also wouldn’t make me cry too hard if my wallet was lost or stolen.
All That I Need
Here’s the beauty of carrying $120—it’s all the cash I ever need.
I probably use cash only about once every few months. Just for the occasional cash-only restaurant, or broken credit card machine, or parking lot that’s cash only.
Even though $120 isn’t a huge amount of money, it’s all I ever need for these rare situations. If my wife and I go out to dinner, it’s not going to be more than $120 (especially at a cheap, cash-only restaurant). If we’re out with friends, it’s even enough to cover a couple more meals as well.
I hate being that guy who doesn’t have cash when I need it (like when a group splits a bill at a restaurant, etc.), so I always like to have some cash. And I’ve never felt like I needed more than $120.
If the cost ever is more than $120, it would be perfectly reasonable to go find an ATM. I always carry my Charles Schwab ATM card in my wallet, which allows me to withdraw money for free at any ATM, and even reimburses me for any fees that the ATM may charge (I need to do a review of Charles Schwab soon—I love pretty much everything they offer…)
The Dream Team
One $100 bill, and one $20 bill—the perfect team. You see, the $20 bill can pay for most of my cash needs (a sandwich for instance). And even if the item is super cheap (say a drink for a dollar), everyone can give change for a $20.
Any reasonable expense that’s over $20 can be covered by the Benjamin. Most people won’t complain about giving change for a $100 bill if the item purchased cost more than $20.
So there you have it. The most long-winded explanation ever for the question, “what’s in your wallet?” Is the exact amount of money in your wallet really that important? Not in the slightest. But I wanted to illustrate the type of things I think we should consider whenever we make financial decisions.
If you can analyze opportunity cost, inflation, federal monetary policy, and the practical implications of how much cash you carry in your wallet, then in my opinion, you’re extremely well-equipped to make bigger and much more important financial decisions. (And if you didn’t realize it already, this post is really about how much cash you should keep in your investment portfolio.)
Thanks for indulging me. This post was fun. Let me know in the comments what you carry in your wallet (and why!).