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All About Emergency Fund Planning
There may be unexpected tax bills to pay, critical home repairs to make or even a recovery from a natural disaster to deal with
Photo Credit : Shutterstock
If there’s one thing that the COVID-19 pandemic has taught us, it’s the critical importance of having a solid emergency fund in place! Personal financial disasters such as the loss of a job, a business folding up and sudden medical emergencies within the family can have devastating effects. More uncommonly, there may be unexpected tax bills to pay, critical home repairs to make or even a recovery from a natural disaster to deal with. However comfortable your current state of affairs might be, it would be prudent to have your ‘emergency fund’ money jar full at all times.
The right amount
The standard advice is to have at least six months’ expenses as an easily accessible emergency corpus. However, this is just a rule of thumb at best. The more ‘volatile’ or unpredictable your present life situation is, the larger your emergency fund needs to be. For instance, an employee at a start-up company should ideally have a full year’s expenses as an emergency fund. On the other hand, a government employee with a more stable income could make do with an emergency fund that’s as small as three months’ expenses. Also, the more dependants and family members you have, the larger your emergency fund needs to be. The scope for drawing upon the support of close family members in case of dire emergencies is also a key determinant of the amount to be planned. Eventually, you could decide on a number that’s between three months and twelve months fixed expenses.
Our over optimism about life often works to our detriment when it comes to getting down to creating an emergency fund. Also, more immediate and pressing financial needs can get in the way. However, this is a financial goal you need to take up on priority.
Two factors will work against you while saving an emergency corpus. One, you need to make good time; taking too long to set up this corpus might defeat the purpose if you’re unlucky. Two, you need to save the money in a relatively non-volatile asset class (given the fact that a sudden drawing requirement might arise). For both these reasons, you’ll need to save in lower risk, lower return instruments for your emergency fund.
You might need to cut a few corners for a fixed duration of time to free up surplus to divert towards this fund. Fewer meals out, shorter vacations, delaying the purchase of a new car or spending less money shopping – these are all ways in which you can create some much-needed monthly savings bandwidth. Think of it as short-term pain for a very important long-term cause.
Whatever you do, do not leave the emergency fund lying in your savings account! You’ll invariably end up spending it. ‘Out of sight, out of mind’ would be an effective rule to follow here. Divert this monthly planned amount into mutual funds through SIP’s (systematic investment plans) instead of accumulating the moneys in your bank account. Even Rs 15,000 per month saved at a return of 6-7 per cent per annum can help you accumulate a reasonably impressive emergency fund within two years. If no drawings are made, this fund can keep growing over time; as you can actually afford to divert a small portion of this money (up to 10 per cent) into higher return, higher risk instruments every couple of years.
Where you should invest
Equity Markets can be quite volatile, and the last thing you would want from an emergency fund is a drawdown. Restrict 60-70 per cent of your emergency fund to liquid funds, floating rate funds or arbitrage finds. Another 20 per cent could be invested into medium duration or dynamic bond funds that are more volatile but carry the promise of higher growth. A maximum of 10-20 per cent of the emergency fund could be invested into equities to provide a small kicker to the overall corpus.
Mistakes to avoid
The first trap is to not start creating an emergency fund at all. Don’t bury your head in the sand and assume that life will pass you by leaving you unscathed - refer the first line of this article! Getting started is key, even if it means doing so with a smaller amount.
The second trap is to make interim drawings to fund lifestyle expenses, with the assumption that you’ll be able to top it up again at a later date. Admittedly, it’s difficult to resist a neat pile of liquid savings when that foreign vacation or fancy new car is staring you in the face. But resist you must, for your family’s sake if not for your own.
The third trap would be to commingle your emergency fund with the rest of your portfolio. When the lines blur, it becomes all too easy to forget why you’re saved up this money. Overtly speculative investments and over-aggressive investing is the most likely outcome of this trap. Resultantly, you may be left high and dry when an actual drawing requirement arises.