Why Emergency Fund is Goal No. 1 ?
Luxury expenses (Car, vacations, etc)
Big Spends (House)
Child Plan (Education, Marriage)
Emergency fund has been listed highest in the order of priority.
Why does one need an emergency fund?
As per Johnson and Widdows (1985), emergency fund is usually needed to continue with the same level of lifestyle in case of any sort of income disruption. You create emergency fund to meet events like loss of job, sickness (and so suffering loss of pay) or accidental loss of assets like car, etc.
This way you can avoid unnecessary stress and focus on returning to normalcy i.e. finding new job or improving health or acquiring new car, etc.
Emergency fund is not to be equated with funds required for meeting sudden medical needs.
In financial planning it is pre-supposed that you have taken adequate medical Insurance cover to provide for expected medical emergencies.
What should be the ideal size of an emergency fund?
As per research [Garman and Forgue (1997), Dunnan (1994)] “the size of the emergency fund could range from 3months to a year of living expenses”.
This of course depends on the individual’s job profile as well as the sector he is working in. So if one is working in a start-up where job losses are more likely as compared to a say a job in the Government sector, the individual should plan to have a bigger cushion, say 8 months of living expenses versus just 3 months for someone working in Government.
In terms of job profile, a person working in support profile is more likely to suffer a job loss in an economic downturn as compared to a person working in a marketing profile and hence would need to have an emergency fund covering more months of living expenses.
The next question relates to the deployment of emergency fund in assets.
By its very nature, the emergency fund should be deployed in assets which can be quickly converted into cash with minimum loss of capital i.e. liquid assets like savings account or even bank fixed deposits.
However since not all of the fund would be required at one point of time (in event of job loss, you would spend eight months of living expenses in eight months and not in the first month itself) you can decide to park funds in assets with varying degree of liquidity.
So for example, for an emergency fund constituting of eight months of living expenses, money equivalent to three months of expenses could be parked in a savings account, next three months could be parked in short term bank fixed deposit and the remaining two months in a money market mutual fund.
If you are more hopeful about your job prospects you could alternatively park a small percentage of your funds into stocks as well.
With the distribution of assets in varying degree of liquidity you would be able to realize a higher return on your assets, thus helping to grow your emergency pool with time.
Finally with your emergency fund distributed into higher return assets, you would be able to reduce the fund contribution. So for example an emergency fund of Rs.10 lakh parked in a savings account is equivalent to a smaller fund, say Rs.9.50lakhs, distributed into savings account, bank fixed deposit and money market mutual fund, since the additional returns enables you to create the same pool.
In summary, efficiency in fund management even for something of uncertain tenure like emergency fund, helps you to create more value out of your investment.
Dunnan, N. (1994). Dun & Bradstreet Guide to Your Investments. New York: Harper Collins
Garman, E.T. & Forgue, R.R. (1997), Personal Finance, 5th Boston: Houghton Mifflin Company
Johnson, D.P. & Widdows, R. (1985), Emergency fund levels of households. In K.P. Schnittgrund (Ed.), Proceedings of the 31st Annual Conference of the American Council of Consumer Interests, 235-241