Emergency Fund 101

"Into each life some rain must fall", said American Poet Henry Wadsworth Longfellow. Perhaps he was implicitly referring to the need for setting up an emergency fund?

From a Financial Planning standpoint, few things outrank the creation of an emergency fund in terms of importance. Personal financial disasters can strike unannounced - and with devastating effects. The loss of a job, a business folding up and sudden medical emergencies within the family are just a few examples. 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 to the brim at all times.

How much is enough?
The standard expert 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 that's more exposed to the elements, so to speak, than one who works at an established firm should ideally have a full year's expenses as an emergency fund. On the other hand, a government employee 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.

Spend some time in self-inquiry and rationally evaluate just how fraught with risk your financial position is, or isn't! Decide on a number that's between three months and twelve months fixed expenses, plus one off but unavoidable annual expenses such as your insurance premiums (car, health and life), vehicle service costs, Diwali bonuses for domestic help and the like.

How should I go about it?
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.

Arriving at the optimal number can turn out to be distressing for some, given that the figure may turn out to be daunting. It would be sensible to define a rational, time-bound goal for accumulating this amount (for instance, two years).

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 in debt funds yielding 9-10 per cent per annum can help you accumulate a reasonably impressive emergency fund of nearly Rs. 4 lakh 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 should I park the money?
Given that the very purpose of an emergency fund is to finance sudden, unexpected requirements, it's imperative that you avoid investing this money heavily into aggressive asset classes such as equities. Markets can be fickle, and the last thing you would want is for a drawing to be made after your emergency fund value has depreciated considerably courtesy a bear cycle. Restrict 60-70 per cent of your emergency fund to short term debt funds, ultra-short term debt funds and liquid funds. Another 20 per cent could be invested into longer term debt funds or strategic bond/ 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. Be sure to place the equity portion last in the pecking order of your drawings, should a requirement arise.

Emergency Fund Planning traps to avoid
In conclusion, let's consider some all too common emergency fund planning traps that even well-meaning and intelligent savers sometimes succumb too.

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.