The coronavirus pandemic has once again reminded us that having a contingency or emergency fund is essential. Whether you’re a salaried individual or a business owner, the immediate lockdown pushed pretty much everyone in a state of panic. The pandemic triggered global financial uncertainty, and markets crashed everywhere. It’s not even easy to sell your investments during these times because you’re either losing the potential future profit or exiting at a loss.
It brings us back to a very frequently asked question: how can one park cash and create a liquid fund? But, before I answer that, why does one need a contingency or emergency fund?
Investments in the stock market are entirely dependent on current events. They’re dynamic and change value every day. In March-end, after the lockdown was announced, India’s stock markets slumped radically. All the profits or gains one had achieved in the last couple of years are gone within a few days. Obviously, the situation will improve over time. But the recovery will be gradual. Exiting your investments at a lower valuation either reduces your gain or incurs you a direct loss.
Additionally, the lockdown erased expected cash flow for most medium and small scale businesses. Salaried individuals braced for pay cuts. Unfortunately, the money coming in reduced. But our liabilities like rent, EMIs, loan repayments, and more continued to exist.
A contingency or emergency fund is supposed to help you in times like these. Not just pandemics or financial meltdowns like 2008, but also personal emergencies. And, this fund or collection of money should be “liquid” in nature.
What do you mean by liquid investments?
These are investments that have a short-term outlook and can be encashed quickly. These are safe options, unlike the volatile stock market. Generally, the short-term investment has a timeframe of a couple of years. It’s called liquid because it is the most “fluid” asset one can have. One that can easily flow.
The point is to park your money without letting its value depreciate due to inflation or demonetization. Keep in mind, cash here doesn’t necessarily mean hard cash. In financial terminology, cash is wealth that can be spontaneously used to carry out a successful transaction. The money in your savings bank account can also be referred to as “cash.”
You contingency or emergency funds have to be liquid in nature. If the need arises, you should be able to turn the fund into hard cash as quickly as possible. That’s why property or real estate aren’t considered to be liquid because it’ll take weeks, if not months, to sell it and have on-hand cash. Similarly, stock markets, ETFs, and physical assets aren’t liquid.
How to create an emergency fund:
- The first step is to make a list of current liabilities. These include loan repayments for your car, property, or business. Then note down your monthly expense or operational requirements (for business). It also includes your bills like electricity, gas, internet, and more. Now you have a figure in hand that suggests your minimum cash requirement for every month.
- If you don’t have lump sum money available right now, start saving every month. These small monthly doses should be able to create a sizable chunk within a year. Your contingency fund should be able to get you through at least three months of downtime (I’d recommend six). There is no definite time frame or rule to follow. But, having a safe enough buffer period helps everyone.
- Also, make a list of expenses that are deemed “luxury.” In case you have to depend on your emergency fund, reduce your spending. Be frugal about the air conditioning, reduce your WiFi speed, or start cooking instead of ordering. These small steps will drastically reduce your expenditure and help cut corners without affecting the primary onus of your lifestyle.
- Most importantly, park the money.
A few suggested options for parking money:
- A few banks in India offer high-yield savings accounts. The interest earned is obviously drastically lower than long-term investments in the stock market. But your money will still be able to grow slowly and defeat inflation. This is the safest way to park since the cash is just one swipe away. But the interest earned is measly, and banks aren’t keen on opening these accounts amid unstable financial markets.
- Some banks offer a Flexi-deposit option that automatically creates a Fixed Deposit (FD) from the money in your savings account. You can redeem your money like a usual savings account, and the system will automatically swap money. It offers a higher return of interest than a savings account while maintaining the same level of liquidity.
- Invest in liquid or short-term mutual funds. This category of a mutual fund is designed to be “liquid” in nature. The asset management company invests in a short-duration investment like 91-day instruments (government T-Bills). The end investments are made in safer instruments like debt-based securities and corporate bonds. Furthermore, “overnight” funds are considered to be the safest in the liquid/short-term category. There is no lock-in period, and you can exit anytime. The rate of return is higher than a fixed deposit.
- Lastly, you can also consider acquiring a liquid asset like gold or silver. These metals are considered to be the most liquid form of wealth because of their inherent precious value. Gold will not lose its value if you’re in a store on Wall Street or in the middle of Syria. However, their prices are dynamic in nature. Meaning, you could end up selling it at a loss if the odds aren’t in your favour. Despite the dynamic valuation, the metal continues to be a highly sought option for liquidity.
The 2008 financial crisis, demonetization, slowdown in the Indian economy, and now the pandemic are notifications that highlight the need for an emergency fund. The goal is to ensure you have money when you need it. Save some for emergencies like this and save the rest of it for long-term risk-oriented schemes that can help you fulfil life goals.
Disclaimer: Please note, this is not a recommendation or financial advice, and is purely for educational purposes. Please speak to a registered financial advisor before making an investment decision.