Illustration by Era Namjoshi for 1 Finance Magazine

We’ve often heard the adage that it is prudent to set aside some money ‘for a rainy day’. But no matter what stage of wealth creation you’re at, you likely have some questions about the dos and don’ts of this cautionary and somewhat vague wisdom. Fortunately, anticipating your needs and preparing for uncertainties is not as complicated as it may seem. 

An emergency plan can insulate you against financial distress, to a significant extent. The idea is to set up a fund that you can draw from in the event of a job loss, medical emergency, business insolvency, or even a pandemic — perils that would otherwise deal a blow to your financial stability. Ideally, you would never have to dip into these funds — nevertheless, it’s vital to build a safety net that helps you stay afloat while you recover from an unforeseeable circumstance. For many, the pandemic served as a wake-up call to start planning intentionally and regularly for future emergencies. 

Building an emergency plan is two-fold, comprising an emergency fund and insurance. An emergency fund or corpus is an amount of money that you set aside — ideally as soon as you start earning, and especially in months when you have surplus income — to cover your living expenses for a finite period of time. Health and life insurance coverage help avert hefty medical bills and allow families to avoid a financial crisis while dealing with the loss of their loved one. 

There are common misconceptions about what an emergency corpus looks like. An emergency fund is separate from your savings and investments because it’s not to be touched unless necessary, and you do not expect returns from it. People tend to consider their asset allocation or insurance as a sufficient safeguard against emergencies. They save a part of their salary when they can, or make short-term investments in high-risk instruments, to set up a fund that would serve them for 1–3 months. Very often, they assume that the fund should account for all their expenses and their entire monthly income. 

Predictably, this approach does not work — people either lack discipline or get overwhelmed by the magnitude of the task at hand. The most effective rule of thumb is to set aside enough money to cover your essential household expenses (since you would not be spending on luxuries in an emergency scenario) and outstanding liabilities (including EMI payments) for a period of six months, though this duration can vary based on circumstances.

To ascertain how much money you need, analysing your spending habits is key. If you currently spend all your earnings to meet everyday expenses, it might be a good idea to reassess your lifestyle and possibly look for sources of passive income. It’s imperative that you prioritise putting together your emergency fund before accumulating savings, making investments and acquiring non-essential assets. Keep in mind that this fund should be liquid for it to be easily accessible when you’re in dire need of cash — a savings account, short-term fixed deposit, bank deposit or recurring deposit is your best bet, provided the money is withdrawable online. This also keeps you from hastily liquidating assets like gold or equity at a loss, or taking on liabilities, in order to meet urgent expenses.

As for the second component — insurance — it is crucial to determine your coverage based on your lifestyle and liabilities, and to avoid being enticed by low premiums. Healthcare is expensive nowadays, and you need to do some forward thinking about anticipated ailments and costs of treatment. A life insurance policy should provide enough coverage to allow dependent members of your family to sustain the lifestyle they are accustomed to and pay off any outstanding debts after the death of an earning member. 

A substantial emergency fund and a thoughtfully selected insurance policy can act as the best safeguard against unforeseen crises. Working towards this is an exercise in inculcating financial discipline, but also a pre-requisite for your financial security and peace of mind.

Discover your MoneySign®

Identify the personality traits and behavioural patterns that shape your financial choices.