Build the Buffer

When young couples come to me and say, “What should we do financially?”one of the first things I say to them is something like, “Build the buffer.”  You should have 3-6 months of expenses saved up.

I sometimes phrase it like this: use the stoplight rule.

  • Less than 3 months expenses in the savings fund? Red light. Defer all discretionary expenditures.
  • 3-6 months expenses in the savings fund? Yellow light. Some discretionary expenditures allowed, so long as you don’t dip back into the red light zone.
  • More than 6 months expenses in the savings fund? Green light. Discretionary expenditures allowed, so long as you don’t dip back into the red light zone.

For what it is worth, the same rule works well with congregational and other nonprofit budgets, for nonprofits without a significant endowment.  It balances mission needs, and donor giving.

But let’s take another look at the buffer, and why you might like to have it bigger.  Consumer finance charges really eat into the incomes of many people.  What if your buffer was so big that you could:

  1. Pay your insurance premiums in annual installments?
  2. Buy your next car without financing it?
  3. Pay off your credit card bills in full each month?
  4. Ask for a discount for cash when buying big ticket items?  (You’d be surprised.  I drove quite a deal with my orthodontist for my wife and eight kids. I’m the only one that hasn’t had braces.)
  5. End the escrow account on your mortgage?
  6. Pay tuition bills in full, rather than a payment plan?
  7. Take advantage of financial crises, and extend credit at tough times?  (I am still receiving 13% from a business associate that I lent money to in March of 2009, with warrants.)
  8. Retain cash in your corporation to reduce financing costs?
  9. Not worry about the minor disaster that recently hit?
  10. Raise your deductibles on your Auto, Home and Health insurance premiums to save money?
  11. Receive discounts on services that you want to receive, by getting a discount for buying years ahead?
  12. Fund your 401(k), IRA, HSA, whatever, to the fullest?
  13. And more…

Even when Fed policy is insane, the low rates do not apply to the masses, aside from GSE-supported lending.  In this environment, Fed policy starves liquidity in traditional lending to send it to the government, and related entities.

So, even though you can’t earn anything by saving, there is still the advantage of receiving a discount for full cash payment up front.  That doesn’t change, and because there are so many with bad finances, that discount is still valuable to businessmen who don’t want to deal with the costs of bad credit.

Now be wise.  When you use your liquidity to buy ahead, plan to replenish the buffer.  Don’t do everything at once; note the limitations of your liquidity, and act accordingly.

This is basic stuff, but I see many neglecting it.   Incidentally, the same rules apply to small businesses.  Being well-capitalized has advantages.  Take advantage of vendor finance discounts where you can.  Seek discounts for prompt cash payment wherever it makes sense.

I’m not saying be a miser and hoard cash.  I am saying there is a happy middle ground where you have enough cash to meet most contingencies and normal needs, and use the remainder to further long term goals and whatever you enjoy.

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About David Merkel 145 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website ( Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

Visit: The Aleph Blog

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