Stop Investing Every Dollar If Your Cash Reserves Are Low — Do This Instead
Investing is one of the most proven paths to accumulating long-term wealth; but, if you invest every dollar you make, it can leave you vulnerable during a financial emergency. That can result in overdraft fees, trigger monthly maintenance fees and force people to sell assets during corrections to keep up with expenses.
A cash buffer acts as a safety net that makes it easier to invest a larger percentage of your paycheck with confidence.
Here's why you need one.
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How You Can Lose Money by Investing Too Much
Investing every last dollar of your paycheck after covering predictable expenses sounds like a good idea until you get hit with an emergency bill. You have multiple options to deal with this scenario, but all of them involve losing money.
If the emergency bill is immediately deducted from your checking account’s balance, you risk incurring an overdraft fee, which is more than $30 at some banks. If the emergency expense takes place on your credit card and you cannot pay it off before the grace period concludes, you will have to contend with a high interest rate.
Waiting for your paychecks to arrive to cover the debt will result in interest accumulation. You will also have a more restrictive budget as you navigate the emergency expense, along with regular monthly costs.
The two options for paying an emergency expense immediately aren’t attractive either. The first route is taking out a loan, which will trigger origination fees and interest payments. The second option is selling some of your assets to cover the emergency expense. This option sounds good during bullish markets, but if the stock market goes into a deep correction, you will be forced to sell more shares at a loss to cover the emergency expense.
How Much Extra Cash Do You Need in Your Cash Buffer?
Each emergency expense compounds all the issues that come with a razor-thin bank account and the relentless pursuit of investing money into assets. A cash buffer can solve these issues by providing enough funds to cover emergency expenses so you can invest a higher percentage of each paycheck with more confidence.
A one-month cash buffer is a good starting point. If you spend $5,000 per month in a typical month, you should have a $5,000 cash buffer. It’s optimal if you can build it up to a six-month cash buffer, which would turn it into an emergency fund. Storing this money in a high-yield savings account will help you grow the account faster.
You will have to build up your cash buffer while keeping up with monthly expenses. Initially, less of your money will go toward assets, but once you establish a cash buffer, you can invest a higher portion of every paycheck without fear.
Invest More Money Once You Have Financial Stability
You should only invest money that you won’t have to touch for at least three years. That timeframe gives an asset enough time to recover from any corrections and to capitalize on long-term opportunities.
FOMO may tempt investors to throw more of their money at the stock market and operate with no cash buffer, but it’s a risky strategy that guarantees stress. Instead of frantically reviewing each bill and daily stock price fluctuations, you can build an initial cash buffer that covers one month of your living expenses. Once you scale up to an emergency fund that can pay off six months of living expenses, you can start investing more of each paycheck into assets.
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal or tax advice.
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