Personal Finance Essentials
Where Cash Reserves Fit in Your Financial Plan
Build This First
Everything Else Depends on It
Cash reserves don’t exist in isolation – they’re one part of a larger financial foundation. Understanding where they fit in the sequence of financial decisions ensures you’re building your finances in the right order.
The Right Order
Before you begin investing in stocks, bonds, mutual funds or real estate, your financial foundation should be: first, participate in your employer’s retirement plan to the maximum allowed; second, pay off all credit card debt; third, build your cash reserves. Only after all three are in place should you begin a long-term investment program.
This sequence matters. Retirement plans offer tax advantages that are too valuable to pass up. Credit card debt carries interest rates that erode any investment gains. And without cash reserves, you’re one crisis away from being forced to liquidate your investments at the worst possible moment – likely at a loss and with tax consequences.
Cash Reserves as a Prerequisite for Investing
Before investing, ask yourself three questions:
Do you carry credit card debt?
Do you have at least three months of expenses in cash reserves?
Can you leave the money invested for at least three years?
Each of these requirements protects you from a scenario where financial stress forces a bad decision at the worst time. The order is not arbitrary – it is designed to ensure your financial foundation is solid before you take on any investment risk.
Cash Reserves in a Portfolio
Even within an investment portfolio, cash plays a role. When managing a diversified portfolio, it is common practice to hold dividends and capital gains in a money market account rather than reinvesting them immediately. This reduces the need for frequent rebalancing, minimizes transaction costs and keeps a portion of the portfolio quickly accessible. Unlike securities – which require three days to disburse – money market funds can be distributed the same day you request them.
Cash belongs in a portfolio, but only in the amount needed. Pension funds and institutional investors follow exactly this logic: they hold enough cash to handle expected pay-out requests and invest everything else. Excess cash is a drag on performance. Once you’ve identified the right amount to hold, invest the rest.
Cash Reserves and Insurance Waiting Periods
Cash reserves also play a supporting role when it comes to insurance. Disability insurance and long-term care insurance both include a waiting period – the amount of time that must pass before benefits begin. These periods typically range from 30 to 365 days for disability coverage.
Choosing a longer waiting period reduces your premiums significantly. A 90-day waiting period is generally the most cost-effective for disability coverage, since most disabilities do not last 90 days. But a 90-day self-insurance window could require $10,000 or more out of pocket before benefits begin. Your cash reserves are what cover that gap. When deciding on your waiting period for any insurance policy, make sure your reserves can actually support the choice you’re making.