You need a strategy-based approach that goes beyond FDs.
Deepti Bhaskaran|First Published: Mon, Jun 10 2013. 08 24 PM IST| Live Mint|
You could be a young individual just starting out with dreamy eyes and tall ambitions or a mid-career worker toiling hard to provide for your family or an individual just years away from retirement. Regardless of where you are in your work life, a sudden job loss is that dreadful event that most of you would like to believe can never happen to you.
The future remains unpredictable, and therefore you need to ensure a financial health that temporary shocks, such as a job loss or medical emergency that impedes your ability to earn, can’t disrupt. In fact, as it turns out that’s the first thing you need to do. You need to build an emergency fund as soon as you start planning your finances. “Individuals should know that emergency fund is the first corpus they should build before making any long-term investment,” says Mukesh Jindal, partner, Alpha Capital, a Gurgaon-based financial planning firm.
This applies to all working individuals including even those with a good asset base. “An emergency fund is needed throughout the work life of an individual since emergencies don’t go away with time. As far as an asset base is concerned, keep in mind that these assets might not be liquid. For example, you may own properties that you can’t liquidate in one or two days’ time,” says Kapil Narang, chief operating officer, Ameriprise India Pvt. Ltd, a financial planning firm. Begin by understanding the meaning of an emergency fund before you learn how to build one.
What is it?
An emergency fund is a safety net that helps you tide over a temporary cash crunch. Not only does it help you get by until you find your feet again, but it also ensures that you don’t end up dipping into your investments made for other goals. “Though it is an important aspect of planning, many people do not set aside the funds for an emergency and many times end up taking high interest loan for an emergency need. To avoid such situation, it is good to create an emergency fund corpus which can be utilized at the time of requirement,” says Anil Rego, founder and chief executive officer, Right Horizons, a financial planning firm.
It’s a common mistake therefore to think that an emergency fund is that little extra money that lies in our savings bank account. “In case of job loss or a health problem, that little extra will not suffice. One needs a suitable buffer which is at least three-six months of expenses,” says Manikaran Singhal, founder, Marvel Investments, a financial planning firm. How much you keep aside will also depend on the nature of your job. “Business individuals need at least six months of expenses. Salaried individuals can also manage with three months of living expenses, but if you are in a volatile sector you need to have provision for more,” says Suresh Sadagopan, founder, Ladder7 Financial Advisories, a financial planning firm.
Begin by taking stock of your cash flows. “Start with a simple budgeting exercise. Once you know your total expenses you can segregate them in committed and non-committed expenses. You can build your cash reserve equivalent to your committed expenses such as equated monthly instalment and kid’s tuition fees,” says Narang.
How to build it?
The next step after understanding the money that you need for a rainy day is to create an investment portfolio so that your money can earn slightly better than what a typical savings bank account offers. “If the emergency fund is too less, it could create pressure and if it is too much, it would reduce the returns. Hence, one needs to have a portfolio of differing liquidity levels and returns so as to optimize the two,” says Rego.
So what are the most important parameters to select the right products to create an emergency fund? “There are three most important parameters. It should be liquid, have no exit load and should give you stability of returns,” says Jindal. Therefore, you can’t bank on your equity portfolio during an emergency. What if the market tanks and takes your money down with it? Or you bank on your house that takes forever to sell?
What you need is a portfolio that maintains that fine balance between optimizing returns and having adequate liquidity. For this, you need a combination of products. Ideally you should start with putting away little in your bank account. “An amount equal to the expenses worth one month is enough in the bank,” says Sadagopan.
After this what instruments you choose will pretty much depend upon your comfort level with the financial products that are available in the market. The basic would be to have a combination of sweep-in account and fixed deposits. A sweep account is a savings bank account that after a particular threshold channels your money into a fixed deposit (FD) automatically and breaks this FD should you face a crunch in your bank account. “Suppose you issue a cheque and there isn’t sufficient balance in your account, the bank will break this FD to honour the cheque. This facility is mostly used by HNIs (high net worth individuals) or individuals with unpredictable income,” says R.K. Bansal, executive director, IDBI Bank Ltd. But you need to keep in mind that a premature withdrawal, as is the case with most regular stand-alone FDs, will invite a lower rate of interest. “The interest rate for the period the money is held in the FD will apply. For FDs below Rs.1 crore, most banks have now waived the pre-payment penalty,” asays Bansal.
But if you are comfortable with slightly more complex products such as debt mutual funds, liquid and ultra short-term bond funds is what you should look at. “You should park 70% of your emergency fund in these products. Many asset management companies today offer mobile transaction and debit card facility for investment withdrawal, adds Singhal.
Liquid funds invest in very short-term securities of upto 90 days whereas ultra-short term bond funds invest in securities with maturity higher than 90 days. Liquid funds usually don’t have an exit load, but many ultra-short term bond funds come with an exit load in the range of 0.1-1.0% if funds are redeemed in say a week to six months. “Ultra short-term bond funds can give slightly more, however they are more volatile than liquid funds but the difference in volatility is negligible and is at an acceptable level,” says Jindal.
Also with this initial buffer in place, you should also consider parking a portion of your money with short-term bond funds. “They give better returns but are more volatile and have an exit load initially. For this reason, you can’t start with them but you need to invest a portion here to ensure a higher return for the overall portfolio,” says Sadagopan. This is also true as most of you may not end up dipping into your emergency fund at all or at least in full.
Having an emergency fund is a very important element of financial planning. And just like it’s critical to have an emergency fund during your work years, you need to maintain a part of it even during retirement to tide over an unexpected cash crunch. And to simply put the money in your savings deposit is not smart at all.
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