Did you know contingency funds should be an integral part of your portfolio? Investment literature states that one should set aside adequate cash or cash equivalents to cover three to six months of living expenses. This corpus helps you during unforeseen circumstances. Let us understand what an exigency fund is and how to create and maintain it.

What it is

An exigency fund acts as a cushion in unforeseen situations such as sudden illness, job loss, family crisis or unforeseen expenses. It helps you avoid using other funds during crises. Ideally, it should be robust enough to cover 12 months’ expenses, but anything close to six months is decent enough.

Key characteristics

Low risk: Emergency fund investments need to be either guaranteed or very low-risk. Investments often have a rate of return directly proportional to the amount of risk they carry. Low interest bearing investment avenues are ideal to create an emergency fund.

High liquidity: Liquidity means how quickly the assets can be converted into cash. A savings account, for instance, is 100% liquid — it is pure cash. government bonds and treasury bills have to be sold, but one needs to wait for the cash (one day for government-issued securities, three days for all other instruments).

Easy access: During an emergency, one needs the money immediately. Hence, it is better to park funds in a way that accessibility is easy. Apart from some cash in hand, ensure that you have a debit card and cheque book facility for the emergency fund account.

With a debit card, you can access money at any time, virtually anywhere. When cash is not readily available due to network problems at ATMs etc, one can use cheques to withdraw cash from the bank.

Creating a corpus

The biggest challenge in building an exigency fund is the large amount of money you have to contribute. For some,  even a Rs 50,000 emergency fund seems out of reach. The good news is, you needn’t build the corpus in one go. You can do it over a period of time. The most important thing is to get started and be consistent. Here are some simple steps to building an emergency fund.

Plug leaks in your budget: Research shows on average households spend at least 10% of their income on avoidable expenses. Identify the leakages in your spending. The leakages could range from ordering too much at restaurants to leaving the lights on.

Leverage auto debit: Often, we use auto debit to pay electricity, telephone and other bills. Similarly, some part of your salary should go towards the exigency fund. By choosing the auto debit option, you are making the corpus grow even if you don’t remember it.

Take small, continuous steps: Having decided on the size of your emergency fund, let small and manageable cash outflows help get you there. Compute how much time it will take you to reach the target.

Boost the fund with stock dividends: Investors often get dividends from their stocks (assuming part of the equity portfolio consists of shares that pay dividends). Divert those dividend receipts to your emergency fund account.

Though that will not make it swell overnight, it will help you get closer to the goal faster.

Even coins count: Ask your family members to offload the change from their wallet in a box, whether it’s R1 or R5 every day. At the end of each month, empty the coin box and remit it to your emergency fund. But, obviously, this technique is only to supplement your emergency fund — don’t depend on it to reach your goal.

To conclude, an exigency fund can make a significant difference between financial failure and success. Everyone must accumulate an emergency fund and reduce the chances of having to borrow money at high interest rates.

The authors teach finance and accounting courses at IIM Shillong

Step by step
* Emergency fund investments need to be either guaranteed or low-risk
* They should be liquid, like a savings account. Government bonds and treasury bills don’t fit the bill
* park funds in a way that access is easy. Also ensure that you have a debit card and cheque book facility for the emergency fund account
* Identify leakages in your spending and divert the funds towards your corpus
* Use the auto debit facility so that your corpus continues to grow even if you don’t remember it
* Divert dividends from stocks to your emergency fund. That will help you get closer to your goal faster

For Updates Check Personal Finance news; follow us on Facebook and Twitter