Lessons from COVID-19 Lockdown: 10 tips to build your emergency fund

Karan Deo Sharma
New Update
Lessons from COVID-19 Lockdown: 10 tips to build your emergency fund

Financial planning - how to build an emergency fund

One of the many enduring lessons from the economic repercussions of the coronavirus has been that it pays to have a pool of savings to dip into during times like these.  Social distancing and the economic lockdown imposed by the government to arrest the spread of COVID-19 have resulted in loss of income and jobs for many people, including salaried individuals.

Even if you never planned your finances prior to this, it is good to remember that COVID-19 will not be the last economic crisis to hit Indians. And if you plan now you will be better prepared for any future crisis. Here’s what you should be mindful about:

1. First, you have to decide where to invest your funds. Keeping money in a savings account is the easiest and laziest way to save. The convenience of easy and immediate access to your funds in the bank account, however, comes with very low returns or yields. At current interest rates of 2.75 to 4 percent – depending on the bank, interest on savings deposits doesn’t even cover retail inflation which is hovering at around 5 percent.

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2. Hunt for instruments that offer higher yields on your investments, so you can beat inflation and gain from the power of compounding. But make a note not to fall for higher yield funds because they also come with greater risks and you cannot access your fund at a short-notice without suffering any meaningful loss in value.

3. Capital or principal protection should be the number one priority for anyone building an emergency fund. This means selecting instruments that offer a reasonably higher rate of return (or interest) without compromising the safety of the invested capital.

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4. Diversification is a good way to achieve the right balance between returns and safety. However, there’s no standard diversification formula. It is a function of your risk appetite, investment horizon (duration of investment) and your age.

5. As a thumb rule, a younger person can take greater risks, which means they can invest a greater part of their savings in risky instruments such as equity or shares. As one moves closer to retirement age, they  should increase allocation to safer but low yield instruments such as bank fixed deposits (FD), post office deposits and mutual funds that invest in top rated corporate and government bonds. Post Office RD currently offers 7.2 percent interest for five-year duration, which is very reasonable in the current environment.

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6. As a general rule, the share of fixed-instruments should be equivalent to your age. In other words, if you are in your late 20s or early 30s, fixed income instruments should be 30 percent of your portfolio, equity should be around 50 percent and special assets such as gold should be around 20 percent.  In practice if you save Rs 5,000 per month, around Rs 1,500 should go towards bank or post FD or recurring deposits, Rs  2,500 should be invested in equity either through mutual funds or directly and the balance Rs 1,000 can be invested in gold exchange traded funds (ETFs), physical gold or gold sovereign bonds.

7. Alternatively, you can start with a recurring deposit in a bank or post office and go for asset diversification after 12 or 24 months once your pool is big enough to make one shot investment in equity or gold.  The strategy however requires some discipline. You should avoid the temptation to spend the money you accumulated at the end of 12 or 24 months. This will be strictly invested in the assets that fit your risk and return profile.

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8. Investment in equity has been a popular way to diversify your portfolio and generate excess return over inflation. However no two stocks are the same and a wrong selection of stocks can wipe-off years of investments in a matter of weeks as it happened in February and March this year. Given this, it pays to stick to high quality stocks that may grow slowly but are likely to fall the least in a market crash thanks to their superior balance sheet.

9. Go for stocks that offer a mix of higher profitability (denoted by high return on equity) and a proven management team. The best strategy is to stick with companies that are market leaders in their respective sectors. Companies with little or no debt on their books do well during times of crisis as they are financially resilient.

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10. Most of the industry leaders are also consistent dividend payers. If you can hold on to these dividend paying companies for say five years or more, annual recurring dividend could become a good source of cash flows. You can invest this recurring cash flow in safer assets such as a bank or post office RD that will further de-risk your portfolio. With this, you can get the best of both worlds.

(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist)

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