Importance of an Emergency Fund
Saving for a rainy day is an age-old concept. Growing up we can hear elders always speaking about it. But we tend to take it seriously only after being hit by a crisis for the first time. Perhaps the coronavirus pandemic has one silver living for some — it has taught us to have a moat for difficult times as pay cuts, furloughs and layoffs have hit the millennial worker particularly hard.
According to a report by jobs aggregator Naukri.com, hiring in India across sectors plunged 60% for two consecutive months in May and June as the Covid pandemic hit. The sharpest decline was seen in the metros — where the club hopping and retail therapy enthusiast urban millennial demographic resides. Moreover, a survey of employers across 25 cities by online job portals MyHiringClub.com and Sarkari-Naukriinfo reveals that 73% of the organizations are planning a pay cut for staff. Many have already done so across sectors. The worst part is we don’t know the Covid pandemic will abate. It might be six months from now or even a year.
An emergency fund is a highly liquid investment or cash that you can access at short notice. However, cash holdings are good for short term emergencies. To prepare well for big crises that happen once in a decade such as a recession one should invest in instruments where the money grows in a safe and steady manner while being redeemable whenever the need arises.
What should be the size of your emergency fund?
Financial planning experts are generally of the view that one should build an emergency fund enough for a six-month runway in case of a crisis. Let’s take a look at some of the factors you should consider while deciding the size of your emergency fund.
a) Number of dependents on your income:
If you are single and don’t have any dependents then an emergency fund that covers your personal costs such as rent and food plus some miscellaneous expenses could be a good place to start. However, if you are the sole breadwinner of a family of four and have parents and kids to support then you have to factor in costs such as school and medicines too apart from the basic necessities
b) Job profile:
The size of your fund needs to take into account the risk profile of your job and industry too as some industries are more prone to economic downturn. The Covid pandemic for instance has completely shattered aviation, restaurants and the auto sectors. If you work in a sector that depends a lot on disposable income, the size of your emergency fund should be bigger.
c) Health risks:
All emergencies aren’t black swan events. In many cases, one needs to dip into emergency funds for a physical ailment or an accident. While a good health insurance cover goes a long way in protecting you and your family, it’s generally not enough to cover all expenses. As such it’s important to take into account health risks while building your emergency fund
Another important factor to consider is your credit situation — is there a large EMI to be serviced every month? Those who have a housing loan or car loan EMI are facing a huge pressure amid the Covid pandemic. Even though the central bank has announced a moratorium on EMIs, interests will continue to accrue. So it’s not a good idea to push payments to a later date as doing so will mean that in effect you will be paying a larger amount towards your housing loan as well as other loans.
Additional Read: Understanding Mutual Fund Terminologies
How to build an emergency fund?
As a first step one should consider accessibility and security of the investment while building an emergency fund. Here are a few instruments one that take into account these factors and should be a part of your emergency fund:
1) Cash and bank deposits
The simplest fund to access is perhaps cash. As such one should always have some cash in hand or in a savings account. According to experts, it is preferable to keep at least 25% of the emergency fund allocation in savings bank accounts as they are accessible 24*7. However, the interest you will earn is around 2.5-4% annually.
You might also consider fixed and recurring deposits. They are easy to break at short notice in case of an emergency. However, you might need to visit a physical bank branch for doing so and there will be some interest penalty.
2) Liquid funds
Investing in a mutual fund is another option. Parking your money in liquid funds could earn you an interest surplus of 2.5-3% over saving accounts. They are also easily redeemable as the money reaches your bank account in a day or two. There are various options such as large cap and mid cap funds with different risk options that one can choose from.
You could consider arbitrage funds too. These are low risk mutual funds that buy securities from the cash market at a low price and sell in the future market at a higher price, thus leveraging the volatility of stock markets for investors’ gain.
You could check out the Moneyfy app from Tata capital to invest in a liquid fund. It has an instant redemption option that allows an investor to withdraw instantly up to Rs 50,000 or 90% of the amount, whichever is lower.
3) Gold fund
Gold is a great way to park funds for an emergency corpus. When you invest in a gold fund, you excuse yourself from the high buying and selling charges associated with physical gold. However, you should be aware that gold funds not only invest in the yellow metal and its miners, but also other metals and their miners.
It is important to consider that investment in gold can be volatile at times as the price of gold is dependent on foreign exchange markets and international gold prices. It is recommended to accumulate physical gold in small amounts or through an SIP.
Additional Read: The relationship between economic downturns and gold
1) For millennials in the age bracket of 25-30 years
Youngsters in this age bracket can afford to go for a slightly higher risk profile. So it would be a good option to put more money in mutual fund SIPs as opposed to a savings account. Since there are SIPs where you can top up even with a meagre amount like Rs 500, even those millennials working in the gig economy, where cash flows could be intermittent, can avail them easily. A good starting point is to trim your expenses slightly to invest in an SIP — maybe go out on three weekends rather than the four in a month to invest in your future self. This way you could set aside a monthly amount for investing into an SIP.
2) For millennials in the age bracket of 31-39 years
Someone in this age bracket is likely to have more responsibilities — hence they need to have a more sustainable emergency corpus. More importantly, they must have a good health insurance plan for the family so that they don’t have to rely on the rainy day money.
The slightly older millennials should allocate equal amounts to bank deposits, mutual fund SIPs, short term debt funds and also consider the gold fund option. This strategy will help create a corpus that is diversified enough to withstand market volatility and also grow at an even pace throughout the investment term.
If you are looking for a hassle-free way to invest in an emergency fund, the Moneyfy app from Tata Capital is a great tool. It allows you to set custom goals based on your profile to fulfil your individual financial needs, no matter which age group you fall in. You can invest in mutual funds and gold funds on the platform. It also helps you compare funds on the basis of category, investment horizon, returns et al. You can set up your desired goals on the app for an emergency fund and accomplish it by investing through either SIP or lump sum investment to protect yourself from any future contingencies.