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ZappChai Explainers - Understanding Emergency Funds

With the word 'recession' doing the rounds more often than you would like, one thing that a lot of folks would like to know about is emergency funds, your pool of liquid (easily converted to cash) reserves that can help you navigate through the tough times were you to lose your job or be forced to take a pay-cut.


In today's piece, we explain what an emergency fund is and why it is important, the factors that you should consider when deciding how much money should be in your fund, and what you could do to reduce your "burn rate".


What is an emergency fund?


Over the last century, we have seen on average one major economic slowdown every decade. As businesses start feeling economic stress they begin laying off employees or 'requesting' employees to take major pay cuts. If you find yourself at the end of one such move, you may find that you suddenly do not have sufficient funds to meet your day to day requirements.


In such times, it is helpful to have a fund that can take care of your daily expenses for the next 6-12 months. This would give you a fairly good runway to sustain yourself and your family during these hard times until you find another job. It also keeps you from tapping into investments that are probably at historic lows in that environment (like equity) letting them grow through the cycle, while also avoiding you having to borrow at extremely high rates that personal loans and credit cards will generally charge.


How much should I have in it?


As MBAish as this answer might sound, it depends. We'll go into the factors though so that you could deal with it a bit better. Before we get into that, getting the most obvious question out of the way, why not have a lot of money in it. Well, as we discussed above, one requirement for where you will keep this money is highly liquidly and highly risk-free instruments. The returns that you get on these instruments are (rightfully) low, and hence you do not want too much of your money parked there.


Coming to your expenses, eight to twelve months of expenses are a good place to start for most folks. If you are the sole earning member in the household, have a higher number of dependents, and work at a "high-risk" job which is effectively a job where you are more likely to get laid off in a bad year (finance, startups, cyclical businesses) you would be better off keeping a slightly larger pool. It is also critical to have adequate insurance for yourself and your family so that any medical emergency doesn't put undue strain on your finances, but more on this in a later post.


What if you don't have enough?


With all said and done, it is possible that you either do not have an emergency fund, or it isn't large enough. If you find yourself in a similar situation, you should probably take advice that most startups should be following all the time - reduce burn. What this effectively means is that you slash all your non-essential expenses for a bit, and build a bit of your reserve. If you have 2 lakhs in the bank and spend 50K a month, you have around 4 months of burn. Bring that down to 25K (It's tough, we know!) and you take that up to 8 months, plus you get to put the 25K you're saving every month to grow your fund!


Disclaimer - This is an informational post for your education and should not be construed as investment advice.


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About the Author: The post is written by Ganesh Nagarsekar. Ganesh is a graduate from IIM Calcutta and has worked with J.P. Morgan and Goldman Sachs, before founding GSN Invest.

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