When it comes to an Emergency Fund, the focus is safety and capital preservation, liquidity and quick accessibility. This eliminates fixed-return investments such as Public Provident Fund (PPF), Employee Provident Fund (EPF), convertible debentures.
The Emergency Fund is not a wealth creation avenue. So returns must take a backseat, and volatile investments must be avoided. Avoid stocks and equity mutual funds. You may need the money during the bear market and would be forced to sell investments at a huge loss.
Liquid and Overnight funds meet the prime requirements of safety and liquidity. Both are open-ended debt fund categories that invest in high credit quality instruments entailing minimal credit and duration risk. Both types of funds have portfolios diversified across high credit quality instruments with minimal duration risk. They are typically accessible within Transaction plus 1 days.
Your Emergency Fund can have the above debt funds and a bank deposit too. It need not be one to the exclusion of the other. You can also build through Systematic Investment Plan in Debt funds as debt funds are tax-efficient if held for over 3 years, with the gains being taxed at 20% (excluding cess and surcharge) after indexation of purchase price. The indexation of cost results in the net tax to be paid on gains to be less than 20%. On the other hand, interest earned on recurring deposits is taxed at the marginal rate and does not offer any indexation benefit.
While building emergency funds, you should also remember these points:
Avoid equity. Because markets go up and down, and it would be a shame if you had to needed to sell when the market was in the doldrums. When it comes to an Emergency Fund, cash is king. You can whine about how much more your money could be earning, but selling in a down market or not being able to access it when you need it is a bummer.
Safety and Liquidity are the only two parameters that should be taken into account. You could consider a liquid fund, an overnight fund, an ultra short term bond fund or a bank fixed deposit. It need not be either, but a combination of such investments.
Some would have a fund of at least six months of basic expenses, while others would prefer 12 months. You need to figure out how much you need for your peace of mind. Also, the amount could vary over different phases of your life. If you were newly married with both spouses earning, the Emergency Fund could even be just three months of expenses. But over the years, if a parent moves in and you have a child, the Emergency Fund must balloon accordingly to take care of additional dependents.
The biggest benefit of an Emergency Fund is the peace of mind and financial stability it can provide. If you’re already short on cash, even a single unexpected expense could adversely affect your overall financial health. The true value of it will only become clear when you need it.
Happy Investing!
R♥Vi
Mutual funds are subject to Market Risk. This is not a recommendation to buy or sell. Past performance is not guaranteed. Fund Wallet is a AMFI registered Distributor of Mutual Funds.
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