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Financial Planning

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Emergency Funds

Previously we have learned how creating a contingency fund, or an emergency fund is an essential step in financial planning. Now let us discuss the different investment options that will help build an emergency fund. These include -

Savings Accounts

This account is one of the most basic methods of building an emergency fund.

It should be ensured that the funds of this account should be used judiciously and it should be ensured that some money out of this fund can be used for investing in higher interest-bearing options.

Bank Deposits

These days, banks offer many different types of deposits to cater to our needs.

One of these include the flexi deposit, which has the following unique features - 

  • You can deposit whatever amount you want in the account. The minimum deposit is ₹500.
  • You can even deposit money multiple times in a month but there will be a penalty for not depositing once in a month at least. 
  • The tenure for these accounts is relatively bigger - the deposit has to be operated for a minimum of 5 years.

Debt Mutual Funds

Apart from the safety net of extra income through interest, debt funds are known to be liquid as well.

Once redeemed, your proceeds can reach your bank account in 2-3 days.

While choosing a method of building a contingency fund, keep the following points in mind -

  • Take tax incidence seriously: 
    As mentioned above, tax incidence should be viewed very seriously, when one selects any instruments for liquidity purposes. 
     
  • Don’t complicate investments made for liquidity purpose:
    As per the amount one needs to save for this requirement will not be significant in relevance to once total savings, the investor should look at simple and minimum instruments.
     
  • Don’t go overboard on liquid investments: 
    It is also necessary for one to calculate and freeze the requirements at some level, so that no one can keep more-than-necessary liquid instruments leading to opportunity cost losses, especially if the additional investments could have been directed into growth schemes having much better rates.

Let us consider a case to understand this concept better.

Pratik and Amrita Ray are a double income earner couple and have been setting aside money to create an emergency fund. Their goal is to have at least a year's expenses set aside for contingencies despite never having dipped into the funds they have accumulated so far. The Roys think it is wasteful to leave the funds in their bank account and wonder if they should invest and generate good returns. They want to know if this is the right approach to build an emergency corpus.

The primary purpose of a contingency fund is to help tide over any shortage of income or an emergency. As the couple's financial situation is secure enough, it gives it the leeway to consider investing a portion of these funds to earn a better return.

Following are the ways to go about this is to split the corpus and invest to ladder the risk : 

  • The Rays' must look at building a corpus which is equivalent to three months' expenses. 
    This should be invested in a secure and liquid product, such as a bank deposit, so that it can be easily withdrawn.
  • They can also look at investing an additional three months' funds in an instrument that gives better returns, such as a short-term debt fund or flexi deposits of banks, without compromising on liquidity.
  • The last tranche of funds can be invested for higher returns by taking more risk. The investments that have a lock-in period should not be considered even if they give better returns since they defeat the essential need for liquidity.

One important feature that the Rays should consider while selecting a higher risk investment is their ability to offer them as security for a loan. 

The blend of investments selected by the Rays' depend on their personal situation and risk profile.

As both of them earn, the stress due to loss of income will be lower. Similarly, if they have accumulated assets that can be redeemed in case of an emergency or loans that can be availed of, such as home equity, it will give them greater flexibility in investing their emergency fund. Any change in their situation will also imply a re-look at the way their contingency fund is invested so that its relevance is not lost.

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