In the Facebook group ‘Asan Ideas for Wealth‘ question about the emergency fund is usually asked every month. Most popular question being, where to invest the emergency fund? Most of the time I reply with the same answer, keep your emergency funds in saving account, at max you can have a sweep facility. But, I realized that the emergency fund is a topic that should be dealt with in a detailed manner.
What is an Emergency?
An emergency is an unavoidable and unforeseeable situation that requires some amount of money. There can be emergencies that are not financial in nature but having some money can help you tackle them. Also, we will be limiting ourselves to emergencies that have a major financial component, for obvious reasons.
Some emergencies might require a substantial amount of money in one go, like a medical emergency. While others can be a little long-drawn like in case of a job loss. Rather than giving just one more theoretical explanation, let’s look at some examples of emergencies. These examples are completely true, either I have faced them or someone who I know personally have faced them.
- Medical emergency where the main earning member of the family is incapacitated. The person might be unconscious, in excruciating pain, or paralyzed, this forces other family members to arrange for the money.
- Medical emergency where the patient needs immediate medical attention and the nearest hospital does not offer a cashless facility for patient’s medical insurance.
- A new job offer where you have to relocate to another city. You might be reimbursed later but at the moment you have to bear the expenses.
- Legal emergencies, where you have to fight a case in a court or a tribunal. I know it might seem far fetched and quite impossible, but take it from me Indian system can put you in a position where you will have no alternative. Either you will have to bear a financial loss or fight a legal case. I use to think the same, and the first case I had to fight was in the Supreme court of India.
- Unexpected job loss, like many have suffered due to COVID – 19.
- Sudden and major malfunction of necessary equipment like laptop/compute, vehicle, some equipment required for your profession (camera for a photographer). Replacement or repair of some high-end equipment can make a serious dent in your pocket.
These are just a few examples from my life which I can share. When considering an emergency you can always assume that ‘everything that can go wrong will go wrong’ and prepare yourself the best you can.
How Much Emergency Fund to Have?
The reality of the situation is you cannot determine the amount of emergency fund, because by definition it is a fund for a situation which cannot be planned. Thus a person should look at his situation closely and should decide the amount according to his needs, rather than following some readymade solution.
The most popular way to determine emergency corpus is to calculate it on the basis of your monthly expenditure. Most advisors recommend having at least three times the amount of your monthly expenditure and increase it slowly. Some recommend six times of the monthly expenditure as the upper limit, while others recommend 12 to 24 times.
Though this method of calculation is widely used but, as with everything else in personal finance the actual calculation vary from person to person. This is because emergencies do not always depend on your income, expenditure, etc. a hospital will charge people with different monthly expenses the same. Thus I advise you to calculate your emergency fund according to your situation. Although I cannot make a suggestion for numerous unique situations, but to help you, I will tell you how I have calculated my emergency fund.
The problem with my situation is that I live a very frugal and minimalistic lifestyle. So much so that my annual expenses are equal to three-month expenses of my friends earning equally. Thus if I maintain an emergency fund based on monthly expenditure even a fund that is 24 times my monthly expenditure will be very low. My method is highly influenced by the emergency situations that I have faced or I have seen people face. So how do I calculate my emergency fund required?
I calculate the amount required to face some of the emergencies that I have an experience of.
- A1: Amount equal to my 6-month expenditure, job loss like situation, although I am not doing any job now so the source of income loss.
- A2: General expenses if I am hospitalized in hospitals near to my home, I take the most expensive hospital in a 5km radius of my house. General expenses include room charges, ICU charges, tests like X-ray, ultrasound, MRI, CT-scan, ambulance charge, etc. How do I know about these charges as hospitals don’t reveal the exact amounts quite easily? Well, I am lucky to have multiple cases of me or a family member being hospitalized (sarcasm).
- A3: Amount required to replace my laptop if it suddenly dies, with a new one having a little better configuration.
- A4: Amount required to replace my two-wheeler.
- A5: Cost of having a decent advocate for at least 5 hearings in the district court. I want to believe that this is unnecessary but my life has already thought me why this is required.
Now for the actual calculation. I started with the aim of having an emergency fund equal to the highest of A1, A2, A3, A4, and A5. I am still adding to it until my emergency fund becomes equal to A1+A2+A3+A4+A5, it’s still not there.
Once I am there I will revisit the calculation and will include some more charges of hospitals around my house like ventilator, and will add to A5 as the cost of having an advocate in the high court. It will be a continuous process as I trust my life will keep introducing me to new emergencies, but now I am better prepared and with each passing day my preparations are becoming better too.
Where to Invest Emergency Fund?
There are few people who ask this question because they have a decent amount as an emergency fund and they understand the effects of inflation. These people are genuinely looking for ways to minimize the erosion in value due to inflation. Then there are those who have no idea what emergency is, no idea about how much emergency fund they need, and they think it is lying idle why not invest it. To the first kind of people I say, you can keep adding to the fund to tackle the erosion due to inflation. To the second type I say, a security guard does not sit idle, in the same way your emergency fund is not sitting idle, it is there to save you when emergency comes.
Now, instead of giving you my recommendation let’s take a look at some of the instruments people recommend for investing emergency funds. We will judge them based on liquidity, risk, and returns they give for increased risk and decrease liquidity. Also, we will assume that you will require the amount within two days of investing because that’s how emergency work.
1. Overnight Funds: This is one of the most popular recommendations, people say it’s quite liquid and safe, what is the harm in investing emergency fund in a liquid fund. Well even if I accept this reasoning, I ask what is the benefit of it? Now I can accept that chances of losing your money in overnight funds is almost nil, but chances of the rate of return falling even below that of a saving account are high. Also, about the liquidity, try to redeem a big amount after the cut-off time if you are lucky enough you will realize the truth about liquidity. Even if we assume that redemption will be smooth you are decreasing the liquidity in comparison to saving account and you might end up getting similar returns. Further short term capital gains vs tax on saving account will reduce the return further. So, in my opinion, putting your fund in an overnight fund increases unnecessary risk without any substantial benefit.
2. Liquid Funds: This option is even more popular than overnight funds. I have seen people recommending to put the entire emergency fund in a liquid fund. Again these being liquid and providing a good return are given as justification for the advice. No mutual fund is more liquid than a saving account, stop saying it’s liquid enough, nothing is liquid enough in case of emergency other than cash in hand. When an emergency comes you will find how getting money from ATM becomes a task, you will be so stuck in managing the situation that even saving accounts will appear less liquid. Redemptions are not always smooth and on time, emergencies don’t allow you to contact customer support. But, what about liquid funds with instant redemption? Okay, even after my rant about liquidity if you are hell-bent on investing in liquid funds, you can invest up to Rs. 55,000 in instant redemption liquid funds, but only if your entire emergency fund is 6 to 7 times the amount invested or more. So, in my opinion, even though there are better chances of liquid funds giving more returns than saving accounts the redemption is not always smooth, thus decreasing the liquidity. Thus you should not invest a substantial amount in a liquid fund, better don’t invest any part of an emergency fund in liquid funds.
3. Arbitrage Funds: I have seen some people giving this advice, although they are so few that I would have ignored this. But one such person is quite knowledgable and sometimes I have learned from things he says. If he is using arbitrage funds for his emergency fund he must have a plan and strategy but I am totally against him advising this to others. People are either completely unaware of arbitrage funds or think that they are very safe. Well, they might be safe, but for long terms. From the moment an arbitrage position is taken until it is squared off, the volatility is very high, this makes these funds volatile for periods up to 6 months. And emergency can strike even the next day of your investment. Further, the arbitrage strategy gives a return in the volatile/trending market, in a sideways market these funds behave as debt fund by nature. Thus the high volatility in the short term and arbitrage funds giving low returns in the sideways market makes them unsuitable for an emergency fund. You are decreasing the liquidity and increasing the risk and you might not end up getting the desired return. No arbitrage fund for an emergency fund is my recommendation.
4. FDs/RDs: For sake of simplicity I will call them term deposit. Now on the face of it, they look like a valid option for investing emergency funds, but there are a few points you should consider. Most banks do not allow you to withdraw money from a term deposit online if you opened them offline. That means if you want to deposit emergency funds you better open a term deposit account online so that you can withdraw it online. But the task of logging into an online portal breaking the term deposit adds another layer, and you will have to ensure that another person from your family can access your online banking portal, which many people want to avoid. So if you can make and break a term deposit online and you are okay with sharing your login details with a family member you can put a good portion of your emergency fund in FDs and RDs, but there is a better option with similar advantages.
5. Saving Account With Sweep Facility: Different banks have different names for this facility. But the working is the same, any additional amount beyond a certain limit is converted into temporary term deposit (FD) and when you withdraw the money these temporary term deposits break without any manual intervention. You can easily withdraw money from ATM and if you are not comfortable in sharing your ATM PIN with a family member you can have a separate sweep enabled saving account for an emergency fund. One thing to consider is you should always choose LIFO (Last In First Out) method rather than FIFO (First In First Out). This means when you withdraw money your latest term deposit will break first, thus the older term deposit will keep on giving you the benefit of compounding. In my opinion, this option should be your default choice unless any other investment is uniquely suited to your situation, which is a rare thing to find.
There are some other options which I have seen people recommend, for example, index or large-cap funds, gold, etc. But these suggestions came so rarely that I don’t think they deserve a separate discussion, very high volatility, and low liquidity it will be stupid to put the emergency fund in these.
The simplest way to judge whether you can put your emergency fund in a particular instrument is that, imagine you are unconscious on a hospital bed, and the hospital does not provide cashless treatment, will your family be able to access the emergency fund within minutes, if no keep your emergency fund in a saving account with sweep facility. Also make sure that your family can access the emergency fund, open a separate account if you have to, and share the ATM pin of that account with family.