Any of us who have a basic understanding of money management and financial planning understand the importance of creating an adequately sized emergency fund. Enough has been said and written about the process of creating an emergency fund, the ideal size for an emergency fund and the most suitable investment products and avenues to create one. A basic understanding of emergency funds can be gained from the graphic below.
But there is a lot more that we as individuals must consider in order to build an emergency fund effectively. Therefore in today's post, I'm going to talk about slightly different aspects regarding emergency funds, which are normally ignored by most investors even though they are no less important.
Knowing when to use our emergency fund is as important as knowing how large it should be and how we should go about funding it. An emergency fund is meant to serve as a pool of insurance for our finances so that our finances do not feel the stress when we are faced with a sudden financial exigency. Therefore, our emergency fund is not meant to be used in order to lend money to a friend or to participate in discount sales organised by Flipkart, Amazon and the likes, or satisfy any other such impulsive desires we may have. For a situation to constitute a financial emergency, it must be something that crops up instantly, entails significant monetary costs, and is something that must be dealt with at short notice without the option of putting it off into the future. And it is only and only when we are faced with such situations that we must dip into our emergency fund. A few examples of valid financial emergencies are given in the graphic below.
We need to be able to analyse our individual circumstances and financial situations, in order to be able to define the situations that constitute financial emergencies in each of our cases. Doing so would reduce the probability of us using our emergency fund in an impulsive manner for all the wrong reasons.
Having an adequately sized emergency fund has gained more importance than ever before, in light of highly disruptive recent events such as the COVID-19 pandemic and the more recent power and energy crisis being faced by countries like India and China. Both of these events have brought economic activity to a standstill at various points of time and have placed a big question mark over the security and stability of our jobs. Also, medical costs to treat COVID in case of an infection are likely to be significant. Therefore, in the current context, we may push the size of our emergency fund to 2 years of expenses instead of the regular threshold of 6-18 months of expenses. This is especially true for those of us working in sectors that are most vulnerable to the ill effects of these events. These sectors include tourism, hospitality, manufacturing and so on. Owing to these disruptive events, displacement periods that come with potential job losses during this period are likely to be significantly longer than usual. And this automatically means that our most significant and consistent stream of income would dry up. As a result, our ability to meet our essential monthly expenses and remain solvent during such periods would be severely compromised. Increasing the size of our emergency fund would reduce any financial impact these events may have on us and help us tide over extended periods of financial stress.
Most people today, especially youngsters, are highly aspirational and aspire to work and live outside their home countries. While it is easier to move between countries and work elsewhere today than say 20-30 in the past, it adds a layer of complexity as far as financial planning for such individuals is concerned. Those who do choose to move abroad for a considerable period of time may not be able to take their families along with them. When such is the case, it leaves the individual exposed to the possibility of having to deal a financial emergency either in their home country or the country where they currently reside. And these emergencies would have to be met in the currency of the country in which they arise. Therefore, such individuals must create and maintain two standalone emergency fund pools of equal size, one each in the currency of the respective countries. For example, in an Indian working in America who has family back in India must create an emergency fund denominated in Indian rupees as well as one denominated in US Dollars. If the individual faces an emergency in America, it can be met by dipping into the dollar denominated pool. If the family in India faces a financial emergency, it can be met by dipping into the rupee denominated pool. Such an approach would make it easier for the individuals living and working abroad to deal with financial emergencies, regardless of the country in which they arise. It would also mitigate foreign exchange risks between the two currencies by eliminating the need for currency conversion.
Two aspects that are often overlooked when it comes to emergency funds are those of augmenting an inadequately sized emergency fund and replenishing our emergency fund after use. Both of these can be achieved through the employment of a few simple options. In order to replenish our emergency fund after use we may divert 5-10% of our monthly savings towards our emergency fund until it returns to the originally intended size. In the event that our emergency funds are inadequately sized, may first look to surrender any non term life insurance policies we may have (at the cost of applicable surrender charges) and divert the net proceeds towards our emergency fund. Another option break any of our FDs which are close to maturity (at the cost of incurring any penalties if applicable). Dipping into our investments must be viewed as the last resort. And even then, we must first look to meet our needs through our debt portfolio through products such as ultra short term bond funds and liquid funds. Redeeming our equity funds is an option that must be reserved only for the most extreme circumstances.
To sum up, the financial needs that modern individuals have, the aspirations they nurture and the issues they have to handle are all continously evolving and getting increasingly complex. Therefore the exercise of managing emergency funds needs to be a lot more nuanced than simply parking a few months worth of expenses in low risk, high liquidity assets. There needs to be a clear process that tells us when to use our emergency fund by helping us define what a financial emergency would be in light of our financial situations. Geographical distances between family members need to be factored in and provided for. The size of our emergency fund needs to be reviewed regularly in light of the real world contexts we are faced with and aligned to suit them effectively. Deficiencies in our emergency fund as a result of usage or inadequacy need to be countered using the right sources as quickly as possible because we can never tell when the next financial emergency may hit us. That is the only way to ensure that our emergency funds stay relevant and are an effective fit for our financial plans. To end this post, look at the graphic below which captures the essence of the post.
