Money magazine says that 78% people will suffer from a negative financial event in a 10-year period.
Lying on the small hospital bed with the IV in his hand and the broken mobile, after the car accident, Mr. Dumbbell was thinking about the next few months and the jolt to his earnings that the car accident had caused. Although medical expenses were not a major concern for him as they were covered by his insurance, his disrupted income stream posed a challenge for the family.
Many of his relatives and colleagues visited him while he was bedridden. Knowing his sudden financial need, some of his relatives and friends offered him help. If he hadn’t got the timely help, he was even prepared to liquidate his assets and investments.
But, each one of us might not be as fortunate as Mr. Dumbbell. So, what do you think he did wrong?
Seeing Mr. Dumbbell’s condition, his colleague Mr. Brainy went home that day and contemplated over this situation. Surprised at himself, that why he hadn’t thought of it before, he kept brainstorming the whole day.
Finally, he had some valuable pointers at the back of his mind, that he was determined to follow.
He realized that life is an unpredictable game. It can throw challenges at anyone, at any point of time. As hardships are never predictable, most of them carry a financial burden along with themselves. So, what should he do? He asked this to himself.
He carefully came up with the idea of having an ‘ouch’ cushion whenever he fell. By this analogy he meant that, he will maintain an emergency fund of money for any sudden adversity in life, that he could depend on in case of unpredictable situations and sleep peacefully at night.
And the most important thing about this fund is its easy accessibility and liquidity, which might not be available with all the financial assets of a person due to the presence of entry and exit charges or lock-in periods or he might not find the market to be favorable for liquidating his assets.
Next, he wondered when to stop? As in, how big should the emergency fund be? It was obvious to him that since he is a sole bread winner in the family and has a temporary job, he needs at least 6 months of emergency fund.
(The more stable your money and household situation is, the less you need in your emergency fund.)
If he had a two-income household or a steady job for several years, then a three-month emergency fund would have sufficed. It is very subjective and it varies from person to person, as per his income stream, number of dependents as well as his current investments.
Next thing that came in the mind of Mr. Brainy was that Where should he keep it? Should he keep it in the same account where he keeps his money right now? No, he realised he shouldn’t, in order to control his desire to splurge the money for leisure, as he will be tempted to do so if it is in the same account and readily available by debit card. So, he should keep it in a separate account that is easily accessible and earmark it as his oops fund.
Next, he decided to ask himself 3 questions before withdrawing money from the emergency fund because When a sudden emergency arises, it can feel like an emergency—but that may not always be true. He thought of 3 questions to determine if he needs to tap into his savings:
- Is it sudden?
- Is it really important?
- Is it very urgent and unavoidable?
(The more he will answer “yes,” the more likely it’s an emergency and the more it justifies using money from the emergency fund.)
So, he started saving from that very day into his emergency account. He was amazed at how quickly his emergency fund piled up as he wasn’t making any debt payments from his income.
(In case there are any debt obligations, the person should try to pay off all the debt first before setting up an emergency fund)
Since he was a novice investor, he made it a point not to immediately put his savings in an investment vehicle, such as a growth mutual fund, but instead create sufficient liquid capital on which he could rely in the event of income loss.
When he was able to meet his emergency fund benchmark, he could sustain his life at the same standard of living for 6 months without any income stream. He also devised a great strategy for not losing on interest income from these funds due to their highly liquid state. It was as follows; –
He divided his emergency fund into two parts,
- Short-term emergency fund
This was his safe haven in times of an immediate emergency. It was easily accessible, and bore little interest. Its purpose is to be ready for smaller emergencies, such as repairs. It can also be used as a bridge to get through the few days until one can access the long-term emergency funds in case of a more extreme situation.
- Long-term emergency fund
It was to save for big emergencies, such as unemployment or disaster, and also to earn a slightly higher level of interest. Accessibility is still important here, but it’s okay to choose investments that take a few days to liquidate – as long as there is a short-term emergency fund in place to cover in the interim.
At the end, he would like to say that everyone should create an emergency fund because life is a roller coaster ride with ups and downs, and no one knows what life will offer next.
Thank you for reading. I hope you enjoyed it. Do leave your views in the comments section below.
PS- (Some of you may wonder that what exactly is the difference between emergency fund and savings…Emergency fund is created for unexpected adversities in life whereas savings may or may not be done with a specific goal in mind.
For example- if you want to buy a house and save money for it, it will be savings but you cannot take the amount from the emergency fund for it. The savings for the house should follow the emergency fund creation.)