Future Proof Your Finances: The Art of Building an Emergency Fund

We've all faced financial emergencies out of the blue—an unforeseen medical bill, a busted appliance, a sudden loss of income, or even a 

cracked phone screen. Emergencies have a knack for catching us off guard, don't they? But here's the thing: while we can't predict when these emergencies will strike, we can certainly be prepared for them.

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Establishing a designated emergency fund that is highly liquid helps us tide over such moments. Even if you can only allocate a modest sum, setting aside funds for unexpected expenses enables you to bounce back more swiftly and resume progress toward achieving your broader goals.

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How much coverage is enough?

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As a general rule of thumb, your emergency fund should cover at least three to six months of expenses. You can decide to set aside more based on the following considerations:

• If you are single and employed at a stable company, set aside expenses worth three months in your emergency fund.
• If you are a double income household, you and your spouse can create an emergency fund worth six months of expenses.
• If you have multiple dependents or are the sole earner in the family, set aside one year worth of expenses in an emergency fund.

Your emergency fund should be over and above any health or disability insurance policies.

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Illustration

Mool Chacha is the sole earner in his household, residing with his homemaker wife and their two school-going children. In preparation for any unforeseen events, it's essential to consider the expenses he needs to cover for a duration of twelve months.

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How to balance risk, return and liquidity for your emergency fund?

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Different asset types offer different returns, contain different risks, and have different liquidity. Liquidity is your ability to withdraw funds when needed - equity investments for example are long term and withdrawing them for emergencies may book large losses. Similarly, breaking fixed deposits loses interest gains. 

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Managing the emergency fund across different classes is a prudent approach. 

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Start by depositing the first 1-2 months of the emergency fund into a basic savings account, followed by the next 3-6 months into bank FDs, and investing the next 6 months or more into Liquid or Arbitrage funds. Safety and liquidity are key, avoid investing in risky assets like stocks.

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Start small by setting up automated transfers and reserve withdrawals strictly for genuine emergencies such as job loss or significant medical bills. Your emergency fund is not for extra shopping or payday shortfalls. Always replenish the fund after any withdrawals.

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