Chapter 3: Emergency Funds
Build an emergency fund to handle unexpected expenses, job loss, or crises while protecting your investments and financial stability.
I (Abhinav Mishra) published my book, ABC of Investing, in 2023, and it’s been 3 years now. To ensure the learning I have shared in the book reaches a wider audience, I am sharing all the content via this new newsletter. Every week, on Thursday, a new chapter will be released.
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I love to write stories, but of late, I have not had a chance to write one. Therefore, let me start this chapter by narrating the story of Divya.
In a small village in Maharashtra, Divya lived with her parents. Her parents ensured she got a good education. For that, they sent her to the best possible school within their reach in the nearby town. Divya was determined and hardworking, always dreaming of a better future for herself and her family. She was well aware of the challenges and uncertainties that life could bring, especially for those living in rural areas with limited resources like her.
Divya’s parents worked as farmers, relying on their meager income to support the family’s needs. They often faced unexpected expenses, such as medical emergencies or sudden crop failures, which would put a strain on their finances. Witnessing these struggles, Divya understood the importance of having a safety net in the form of an emergency fund early in her life.
With this knowledge in mind, Divya started saving money at a young age that her father used to give her for food and travel. She would set aside a small portion of her pocket money and earnings from odd jobs she took on after school in town. Divya’s friends often wondered why she would save her money instead of spending it on toys or treats as they did.
One day, a devastating flood hit the village, destroying crops, homes, and livelihoods. Many families, including Divya’s, were left with nothing. While the community struggled to recover from the disaster, Divya’s family had a ray of hope. Thanks to her diligent savings, they had an emergency fund that could help them during this difficult time.
Divya’s family used the emergency fund to meet their immediate needs, such as food, shelter, and medical care. While they faced challenges like everyone else, having the financial cushion provided a sense of security and allowed them to focus on rebuilding their lives without having to worry constantly about their basic needs.
As time went by, Divya’s family managed to recover from the flood’s aftermath. They used a portion of their savings to invest in new farming techniques and diversify their income sources. It helped them become more resilient to future uncertainties, such as erratic weather patterns or market fluctuations.
Divya’s story spread throughout the village, inspiring others to prioritize building their own emergency funds. Families realized that having an emergency fund was not just a luxury but a necessity for a secure future. They began setting aside small amounts regularly, creating a culture of financial preparedness in the village.
Over the years, the village transformed. The presence of emergency funds acted as a shield against unforeseen events and allowed families to weather storms with greater ease. People were able to access education, start small businesses, and improve their overall quality of life.
Divya’s dedication and foresight, coupled with the power of an emergency fund, not only helped her family but also uplifted an entire community. Her story serves as a powerful reminder of the importance of financial preparedness, showing that a small act of saving today can lead to a brighter and more secure tomorrow.
If she can create an emergency fund, what stops you from creating yours?
I do understand your problem.
● Understanding the importance: I hope the above story helped you understand the importance and need for emergency funds.
● How do you go about it?
In the remaining chapter, I will help you overcome your second problem. There are two sub-questions to the second one that you may be seeking answers to:
● How much should I keep in an emergency fund?
● Where should I keep emergency funds?
How much?
Before we decide how much to keep in emergency funds, let me discuss the factors that determine the amount you need to have in your emergency fund:
Factor 1: Monthly expenses
Calculate your average monthly expenses, including essential bills, groceries, rent/mortgage, insurance, and any debt payments.
Factor 2: Income stability
Assess the stability of your income source. If you have a steady job with a low risk of job loss, you may lean toward the lower end of the three- to six-month range. However, if you have a more variable income or work in an industry with higher job volatility, it may be wise to aim for the higher end of the range or even more.
Factor 3: Individual circumstances
Consider factors like your health, dependents, and insurance coverage. If you have dependents or health issues, you might want to err on the side of caution and aim for a larger emergency fund.
Factor 4: Risk tolerance
Evaluate your personal comfort level and risk tolerance. Some individuals prefer to have a larger emergency fund for added security, while others may be comfortable with a smaller fund and rely on other forms of financial flexibility or insurance coverage.
The thumb rule is that you must have somewhere between 3 and 6 months of your monthly salary in emergency funds. I have kept five months of my monthly salary in an emergency fund. You can take into account the above factors and come up with your own. (How much are you keeping in your emergency fund -)
Where to keep it?
At present, my entire emergency fund is in fixed deposits. The reason is simple: the returns are good at present. However, when FD rates are low, we need to consider other options. I am listing some of the options you may explore for emergency funds. You may not understand them now, but once we discuss debt mutual funds later, you can revisit this section for a better understanding:
1. Liquid Funds: Liquid funds are a type of mutual fund that primarily invests in short-term debt instruments. They offer relatively higher returns than savings accounts, and the investment can be easily liquidated within a short period (typically one to three business days). Liquid funds provide stability and flexibility.
2. Ultra Short-Term Debt Funds: These funds invest in debt securities with a slightly longer maturity than liquid funds. While they offer slightly higher returns, they may also have a marginally higher risk. Nevertheless, they provide good liquidity and can be an option for emergency funds.
3. Overnight Funds: Overnight funds are a category of debt mutual funds that invest in very short-term instruments with a maturity of one day. These funds carry minimal interest rate risk and provide a high level of liquidity, making them suitable for emergency funds.
Don’t make this mistake
Most investors consider emergency funds an investment. It is not your investment and should never be touched until and unless there is a real emergency. Your goal should be that your money in the emergency fund grows at a rate that beats inflation. For this reason, I said that when the FD rates go down and are unable to beat inflation, you need to consider other options.
Credit Cards as emergency funds?
While discussing emergency funds with investors, I have heard statements like, ‘I have Rs 2 lakhs in FD under the emergency fund, and my credit card limit is Rs 2 lakhs, so I am maintaining an emergency fund equal to 4 months of my monthly income.’
Some may disagree, but I don’t think credit cards should be included in your emergency funds. First, as I said, you should never use your emergency funds, and you use your credit card monthly. An emergency can come in a month when you have already utilized 60% of your credit card limit.
Credit cards can be used as a cushion but should not be relied upon for emergencies.
Here are some more points to support my view:
Reason 1: High-interest rates
Credit cards have high interest rates, especially if you carry a balance from month to month. Relying solely on credit cards for emergency expenses can lead to accumulating significant debt and paying a substantial amount in interest over time.
Reason 2: Acceptance and availability
While credit cards are widely accepted, there may be instances where they are not, particularly in emergencies or certain locations. It is essential to have alternative payment methods or backup funds to ensure you can cover your emergency expenses.
Reason 3: Potential overspending
Credit cards can make it easier to overspend since the funds are readily available. Relying solely on credit cards for emergencies might tempt you to spend beyond your means, leading to more financial difficulties in the future.
I request that all readers take this chapter seriously. Emergency funds are a must, just like life insurance. I want every reader to have both and hope you never get to use either. With the creation of an emergency fund, you are almost ready to learn about investing.
Just a small hurdle that I will cover in the next chapter - Understanding Money.
“Having an emergency fund is like having your own superhero to rescue you when life throws you a curveball.” - Unknown
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