The emergency fund idea is grossly misunderstood

However, it's universally known that funds kept aside for unforeseen situations constitute an emergency fund. This isn't a novel idea. But the perspectives people hold towards it, like the affluent individual mentioned, prompted me to pen down my thoughts.

It's undeniable: Every single one of us will face emergencies. And just to be clear - wealth doesn't grant immunity from life's unexpected challenges!

Thus, the importance of an emergency fund is universal, regardless of financial standing.

Delving deeper into the concept of an emergency fund: It's essentially savings set aside for unplanned expenditures – whether it's for personal use, family needs, extended relations, or aiding a friend in crisis. The emphasis here is on the word “unexpected".

And because it is unexpected, there are two more words that apply here: “safe" and very "liquid".

In effect, this is sacred money, which needs to be in a very safe place so that as and when you need it, it’s available to you at short notice.

Makes sense?

Well, if you get this, everything else about emergency monies is straight forward.

One question that needs to be answered is how much money you need to set aside.

This is going to be very personal for you, and only you will know how much money to set aside. From what I have seen and learnt over the years, a fund comprising one-to-two years worth of income is a good way to start. For some of you it may be less, for others more.

Now, I am sure that’s a lot of money for you to set aside. Don’t let that put you off. You need to start building a fund, and, over time, aim to hit the goal you have set for yourself.

Let’s move to where to keep your emergency fund.

First, let’s talk stocks/equity funds. Now, if we go by our criteria, stocks are not “safe" especially when money could be needed unexpectedly. You don’t want to be in a position where you have to sell you shares in a bear market. Yes, they are liquid, and you could perhaps get your money back within a day. But then what’s the point if you will not get all your money back!

Second, let’s take property. Here, other than the fact that the price of property could be volatile and hence not “safe", it’s not liquid too. You never want to do a fire sale if you can avoid it.

Third, gold is a good option. You can store it easily, and literally exchange it for its market determined, widely known value over the counter. There is some price risk, but not as much as stocks perhaps. By this same measure, diamonds fail since there is no openly available market determined price for the specific diamond/s you may be holding. You are the mercy of the jeweller.

Fourth, is fixed deposits (FDs), which is perhaps the best option. You could choose a bank and keep your money there. Again, the idea is to keep the money “safe", and not earn the maximum return. Liquidity too is very high.

Fifth, is debt funds. This is something that I hear often. Well, debt funds can be, and are, risky. So, they definitely fail the “safe" test. Yes, one could opt for liquid funds, but there too you need to select funds which are not taking unnecessary risk by lending money to high-risk companies. So yes, liquid funds are an option, but one needs to choose very carefully.

And there could be more options as well. But you get the picture.

If you evaluate the investment from the prisms of safety and quick access to funds, and NOT returns, very few investment options fit the bill. Perhaps an FD in a bank like the State Bank of India would top the list.

But that’s just me and my perception of riskiness, or lack of it.

I don’t want to dwell too much on what could happen if you do not have an emergency fund. I am sure you understand that there are only a few ways to plug that gap when it arises – loans or sale of assets. Either is not an optimal option.

The emergency fund really has no substitute. I hope you will consider it and start the journey to building it up. Irrespective of whether you are wealthy or not.

Note: A kind of emergency that we tend not to discuss is a systemic emergency. Where something goes horribly wrong to the whole system, local, domestic, international or even global. In that case, there are even fewer options for you. One of those would be physical gold. I discussed this briefly in an earlier piece.

Rahul Goel is the former CEO of Equitymaster. You can tweet him @rahulgoel477.

You should always consult your personal investment advisor/wealth manager before making any decisions.