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Financial Planning

Why create emergency fund before starting to invest?

03 March 2017
Planning to start investing? Make sure you have an emergency fund ready!
 

By Sunil Dhawan 

One of the few initial steps in the financial planning process involves taking care of unforeseen risks. Besides getting protected through health and life insurance, one needs to create a corpus so as to meet any other financial risk. Unless one has a proper emergency fund in place, starting to invest for long-term goals may be futile. Let's see why and how to create such an emergency fund. 

Why create an emergency fund: As the name suggests, emergency situations arrive uninformed and also need immediate action. There could be a setback to one's earning capacity due to a temporary disability or there could be job-loss running into a few months. Even a medical emergency may crop up at a time when the claim is taking time for settlement or the ailment itself may have a waiting period. In all such cases, one may have to arrange funds to tide over the situation. Whether it's meeting the household expenses for over a month or honoring commitment towards loan EMIs, certain cash outflows are sacrosanct. 

Emergency fund is not for meeting your planned goals, but only to act as a safety net. 

Related: How and when to de-risk one's investment portfolio 

The cost of not maintaining emergency fund: In the absence of an emergency fund, one may have to either borrow from friends, relatives or take a personal loan and service it by paying interest. If the requirement is huge, one may even have to pledge gold to tide over the situation. If none of these work, one is left with no other option but to break one's existing investments. Doing this, one not only jeopardizes the long-term goals for which the funds were earmarked, but also dents the power of compounding. 

Related: Why investing early is important 

How much fund?: Although, there's no fixed rule as to how much of emergency cash one needs, but as a thumb rule, three to six months' household expenses can be one's emergency fund. The amount should give you the confidence to combat financial emergencies in your household. Vivek Karwa, Investment Advisor & Wealth Creator, VRIDHI.co.in, has an interesting observation. According to him, "Instead of following the rule blindly, consider your work profile and the insurance cover you have. If your job is very safe and you are amply covered with health and disability cover, then it would be fine if you hold just a month's expense as emergency fund. In extra ordinary situations your existing investments may come to rescue. If you are not in a safe job, then holding six months' money is also ideal. Whatever said and done, get a health insurance cover since that's one biggest factor." 

Where to park the emergency savings: As the requirement to access the funds may arise anytime, park the funds earmarked for emergency needs in liquid assets. For better management, one may keep half of the fund requirement in savings account or a sweep-in fixed deposit while other half can be put in short term or liquid mutual funds. A liquid mutual fund invests in debt instruments such as treasury bills, commercial paper and call money market that have short maturities. The returns are therefore stable and less volatile. Their objective is to preserve the capital, have liquidity and a decent tax-efficient return especially after three years of holding it. 

Related: Lazy investor's guide to investment [eBook] 

How to build emergency fund corpus: There are two ways to go about creating such a fund. In the first approach, somehow manage to earmark the necessary amount equal to six months of expenses towards emergency funding. This would mean cutting down on some discretionary expenses till the time adequate buffer is created. The other way is not to be so aggressive in the approach, rather start putting aside regular contributions from one's take-home pay towards such an emergency fund. The idea is to build up such an emergency fund soon so that other goals of life are taken care of early. Karwa says, "If you are looking at investments which are risky and also have lock-ins, then it's advised strictly to first create an emergency corpus and then invest since you will have no access to your own wealth if the need occurs before the lock-in period gets over. In other cases, you can very well go simultaneously." 

Conclusion: Youngsters may need to consider creating such a fund more seriously. As one grows up, liabilities increase, situations change and therefore addressing the concern of dealing with emergencies might take a back seat. And, once you feel confident of its adequacy, avoid any temptation to dip into it, to gift your spouse that new gadget. 

(Readers are advised to consult their tax advisor for detailed advice.) 

Source: Economic Times

 
 
 

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