In emergencies, liquidity is king

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emergency fund

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The COVID-19 outbreak in India is wreaking unforeseen damage on household finances by leading to runaway expenses, interrupted incomes and a heightened risk of job losses. This has served to underline that a contingency or emergency fund should be the starting point of any financial planning exercise. But how large should this emergency fund be and where should it be invested? This crisis offers a few lessons.

Insurance isn’t enough 

Buying insurance is no doubt the most cost-effective way to protect your finances from unforeseen risks and a life and health insurance cover are therefore must-have components to your financial plan. But the COVID-19 emergency tells us that there can be certain kinds of risks that even insurance companies don’t budget for. To deal with them, you need your own emergency fund.

Some health insurance policies specifically exclude illnesses caused by WHO-declared ‘pandemics’ from the scope of the cover.

Holders of health insurance policies are discovering multiple clauses in the fine print of their polices that may prevent them from filing claims if they are required to take treatment for a COVID-19 infection. Most health policies only cover claims towards hospitalisation, with the minimum requirement of the patient spending 24 hours receiving in-patient treatment. If stretched hospital capacity requires you to self-quarantine at your home or use standalone facilities, health policies may not cover such expenses. Some health insurance policies specifically exclude illnesses caused by WHO-declared ‘pandemics’ from the scope of the cover. While new-age insurance firms have rolled out specific insurance products targeted at COVID-19, these carry quite a few ifs and buts too, one of the clauses being that you should not have travelled to the affected countries or been in contact with a COVID-infected person.

Nor is gold

When disaster strikes, one asset that is almost guaranteed to shoot up is gold. Gold has proved a doubly good diversifier for Indian investors because gold returns in India get a lift both from global bullion prices rising and from the Rupee weakening against the dollar. In India, gold prices are up over 27 % in the last one year and 7 % in the last 3 months. But while it may deliver returns when all other assets are tanking, gold is somewhat ineffective as an emergency asset because it can be quite difficult to liquidate at market price.

If you own physical gold, raising cash in an emergency would require you to take big haircuts (a minimum 10-15%) towards wastage and making charges when selling it back to the jeweller. This significantly undermines its safe-haven value. Gold Exchange Traded Funds and Sovereign Gold Bonds are better options but given their uncertain trading volumes in the market and prices moving way off the underlying value, they can be difficult to liquidate too. Of the 11 gold ETFs traded on the exchange, 5 reported traded value totalling less than Rs 50 lakh for the day on March 24.  They have proved to be quite difficult to liquidate in bulk lately with prices way off their prevailing NAVs. None of the listed Sovereign Gold Bonds registered traded value of even Rs 50 lakh, with over 10 of the tranches recording zero volumes.

Therefore, while it may be effective as a haven asset in terms of returns, gold too, in its various forms isn’t useful to raise quick cash in an emergency. 

Read this to know what to expect from Gold return rate.

Liquid funds interrupted

Liquid funds, believed to be good parking grounds for your emergency money, have proved to be a dicey proposition in this crisis too. With foreign investor selling roiling the debt market, corporates withdrawing for advance tax payments and dividends and dealers and other debt market personnel unable to get to work during the lock-down, the short-term debt market has seen price falls (and yield spikes), leading to investors making unusual NAV losses from this category. Read this story on why Liquid Funds Returns are falling – for a full account.

The relatively narrow trading in the Indian debt market, with limited active participants, also tends to aggravate price moves when one-off events like this hit. Redeeming your liquid fund units can therefore entail unnecessary sacrifices too, at times like this.

Overall, the lesson seems to be that, at times of extreme adversity, liquidity – or the ability to convert your investment into hard cash at short notice – is the only useful attribute in an emergency fund.

Overall, the lesson seems to be that, at times of extreme adversity, liquidity – or the ability to convert your investment into hard cash at short notice – is the only useful attribute in an emergency fund. Clearly, when choosing assets for your emergency fund, it is best to ignore the temptation to look for better returns or tax-efficiency and look only for one quality in the asset – quick liquidity.

Stick to top banks

We at PrimeInvestor believe that your emergency fund needs to be first parked exclusively in short-term deposits with the leading banks, which you will be allowed to break instantly online. Given that even bank deposits can give you nightmares at times (as the Yes Bank episode proves), it makes sense to stick to stick to systemically important banks such as SBI, HDFC Bank or ICICI Bank for these deposits without venturing into smaller or newbie banks for an extra few percentage points in returns. When crisis strikes, it also pays to have one month’s living expenses as hard cash at your home, to tide over any inability to stir out on non-operational ATMs (this happened during the Chennai floods).  

Emergency fund – How much?

To arrive at the size of your emergency fund, you need to total up the living expenses that you incur towards your rent, home maintenance, food, grocery, utility, conveyance, education, basic repairs and medical bills every month. If you have outstanding loans towards which you pay EMIs, this needs to be added too. Discretionary expenses such as those incurred on eating out, entertainment etc can be left out. Financial planners in the global context recommend holding an emergency fund equal to six months’ expenses.

PrimeInvestor’s emergency fund portfolio suggests parking 3-months expenses in FDs and another 3-months’ expenses in liquid funds. That is the bare minimum.

But extraordinary circumstances such as the present one may call for a higher cushion such as 9 months. Consider building a fund equal to 6 months’ expenses to start with, adding to it as your income ramps up, especially to cover any job losses. In the Indian context, where the number of family members dependent on you may be high, it would be best to arrive at the monthly expenses for your family while calculating the emergency fund. The fund would also have to cover more than 9 month’s expenses for the self-employed, those with contractual employment or lumpy earnings. Those employed with start-ups or in sectors more prone to layoffs (financial services or IT, for instance) will need to maintain a larger emergency fund to take care of job losses that can accompany a crisis. Such a fund will need a higher proportion of short-term FDs.

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