Building an Emergency Fund

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A contingency corpus is your defence against unforeseen circumstances. Here are the points to keep in mind while setting up one for yourself

 

Do you really need an emergency fund?
The importance of setting up such a fund cannot be exaggerated. Everybody should have one, though some don’t need to put away the requisite amount if they have enough assets. It is often argued that you don’t need emergency cash if you have a credit card. A credit card does come in handy when you face a financial crisis, but the cushion that plastic money provides lasts only 15-30 days, till the bill arrives

How big should the corpus be?
Your emergency fund should be large enough to take care of your living and other essential expenses, such as house rent, school fees, health care and insurance, for 3-4 months. A corpus smaller than this defeats the purpose of setting it up. On the other hand, don’t allocate too much money to it either. Some financial planners err on the side of caution and recommend putting away 8-9 months’ expenses for contingencies. However, this can lead to a lost opportunity because you are locking away a large sum in low-yield avenues.

Where should you invest the money?
There was a time when gold was seen as the safest investment for tiding over bad times, but parking emergency funds in it is no longer a prudent decision. Gold gave negative returns last year and 2014 may not be any different. While paper gold is trading at a premium, physical gold will incur high making charges. Instead, the emergency fund should be stashed in a liquid option, such as a sweep-in bank account or an ultra short-term debt fund. The money in a sweep-in account is immediately available, while the redemption proceeds of debt funds reach you bank account within one working day.

Should you consider equitybased options?
Investors are unlikely to find the 6-7% offered by sweep-in bank accounts and short-term debt funds too attractive. After all, the stock markets are upbeat and analysts believe a bull run is around the corner. Why not invest the emer gency fund in a good equity-based option for better returns? Recall the situation in 2008, when stock prices fell off the cliff and jobs disappeared almost at the same time. Imagine having to redeem your investments to tide over an emergency when the stock markets are in the red.

How to save for the contingency fund?
Don’t try to build the corpus too quickly. It will be a burden on your cash flow and derail other plans, such as saving for retirement or child’s education. If you haven’t already established an emergency fund, start putting away 10-15% of your monthly income for this purpose. This will help you build a corpus in about two years. Any windfall gain, such as a tax refund or an annual bonus, should also be diverted to it. However, it is important that this amount be treated as sacrosanct. Under no circumstances should you dip into it for discretionary expenses.

 

 

 

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