Why an emergency fund matters when stock markets crash and how to build it

Suyash, a video editor working with a social media influencer in Mumbai, started his investment journey three years ago, putting his savings into three to four different types of equity mutual funds every month.

Even though he consumed a lot of content about keeping emergency funds in safe instruments like fixed deposit, he was convinced that putting any money into an FD would be a waste because inflation would eventually eat into the value of his investment.

Moreover, for almost two years of his investment journey, Suyash saw his portfolio in the green. He believed it would always remain that way and would help him fund any emergency. So, why waste any money on an FD? he thought.

He was right for most of his short investment journey, until the current market crash gave him a reality check. He is now facing a financial emergency, but his portfolio is in the red. His only option is to redeem his units at a loss to meet the emergency, after three years of saving diligently.

How could Suyash have avoided this situation?

Suyash could have avoided selling his mutual fund units at a loss if he kept some money separately in safer instruments like a fixed deposit. Such a strategy would have given his equity portfolio some time to recover while allowing him to meet his financial emergency with ease.

But Suyash is not alone. Many investors do not have an emergency fund strategy. If you are also like Suyash, this may be the right time to revisit your strategy. Here are some points that will help.

Emergency Fund purpose

An emergency fund is meant to fulfill a person's most basic physiological and safety needs, providing security and a sense of well-being

The primary focus of an emergency fund is defensive. It can provide you a financial safety net to cushion against major life shocks such as job loss, market crash, health issues, family needs and more. In such situations, an emergency fund can prevent you from taking expensive loans or selling your assets at a loss.

Specifically, an emergency fund can protect you against the following:

• Loss of income: Whether due to job loss, reduced hours, or disability, an emergency fund can bridge the income gap, especially during the period before any disability insurance begins, or you find another source of income.

• Property damage and unexpected expenses: Even with a solid insurance portfolio, sudden expenses like a broken appliance, a damaged car, hospitalisation, or a major home repair will require out-of-pocket payments due to policy deductibles and limits.

How much you should keep in an emergency fund: The 3 to 6 months rule

Traditionally, financial advisors have suggested maintaining an emergency fund equal to three to six months of expenses. This is measured by the basic liquidity ratio, which identifies how many months an individual could meet his/her expenses by using liquid assets after a total loss of income.

However, instead of relying completely on the traditional thumb rule, one should opt for a customised calculation.

For instance, you can calculate your actual monthly income needs (after subtracting work-related expenses like transportation) and multiply that figure by the number of months you anticipate being without income. From this amount, subtract your currently available financial resources, such as liquid assets, to find the emergency fund you need to maintain.

Where to keep your emergency funds?

As the primary objective of an emergency fund is 100% safety and liquidity, you should ensure it is readily available and easily convertible to cash. Some of the popular instruments for keeping smaller emergency funds are savings accounts, fixed and recurring deposits in leading banks as well as liquid funds. Depending on circumstances, one may also keep some cash in hand.

For larger emergency funds, you may use the laddering technique by investing in FDs or liquid instruments that mature every few months. While doing so, you should ensure that these instruments do not have unreasonable penalties for early withdrawal.

You should never have emergency funds in stock market-related instruments such as shares and equity mutual funds. In a market crash situation, the value of your investment can easily drop 5% to 10% exactly when the money is needed. You should also avoid using accounts like NPS, PPF, EPF and life insurance schemes for emergency funds, as withdrawing from them may take significant time.

While many investors do not have enough cash on hand to build an emergency fund immediately, it can be created gradually.

Many investors, like Suyash, are also not psychologically ready to put their money into a low-yield savings account, as they always want to see their wealth grow. Such investors can still build an emergency fund by putting some amount in a fixed deposit-type instrument while simultaneously investing the balance in growth assets like shares and equity mutual funds.