What is an emergency fund and why do I need one?

This financial emergency could be in the form of

Medical expenses
A job loss
Repair work to your home or car
Unexpected travel expenses
or any other tough time.
2020 taught us the importance of saving for uncertainties, when unemployment rose and people started redeeming from their investments and increasing their debts. Having an emergency fund keeps you away from tapping into mutual funds reserved for long term goals.

How much to save

It is recommended that you need to have enough money at your disposal that can keep up with your consumption pattern for ideally 12 months. If your monthly expenses are Rs 50,000 then your emergency fund should save 50,000×12 = Rs.6,00,000 for your emergency fund.

However, the size of your emergency fund will vary depending on your lifestyle, monthly expenses, income, and financial dependents. Those who have EMIs or higher monthly expenses might need to start building a larger emergency corpus. If you have no financial obligations or if you are young, you can reduce your weightage to six months’ worth of expenses.

Where to invest

Follow the SLR (safety, liquidity, and return) philosophy while building this corpus. Consider financial instruments that prioritizes safety and liquidity of your money over returns. Consider bank deposits and liquid funds (with a short duration of 3 months) for building your emergency corpus. Those who are beginning to save can start with one month and then gradually build it up from there. As per SEBI norms, liquid funds invest in debt and money market securities with maturity of up to 91 days. The invested money is parked in market instruments such as Certificate of Deposits, Commercial Papers, Term Deposits, Call Money, Treasury Bills, and so on.

Things to consider when building your emergency corpus

Liquidity: Liquidity refers to how quickly your investments can be converted to cash. Invest in instruments that does not attract high penalties or exit loads.

Safety: Avoid saving in instruments that have high risk for capital erosion, instead, prioritize safety over returns.
Co-relation with other asset classes: Your investment portfolio has several asset classes, it’s important to evaluate how your emergency fund fits in with the rest of your portfolio.
Risk appetite: If you are conservative and have a low threshold for risk, you might want to consider a higher sum dedicated to your emergency fund.