Most discussions on markets are centered around the risk factors, where they can originate from and when, and what can trigger them. This is somewhat similar to an architect sitting and wondering when the next earthquake will strike, at what time and where its epicentre will be. Since this is a futile pursuit, he instead focuses on how well he can design the building so that it is able to withstand the shocks, as and when they strike.
This has clear parallels in personal finance. Debating about what the next big risk is often futile or at best just academic. On the contrary, it is far more productive to prepare yourself and be ready for when the next calamity comes knocking at your door. You simply cannot avoid the kind of economy-wide systemic risks that the pandemic caused, but you can survive them.
In this article, we discuss about the importance of having a safety net and how it can hold you in good stead during the next crisis.
Your safety net, or contingency planning, is your power backup in case the lights go out. This is the first and the most crucial line of defence. Unfortunately, it is often the most neglected one. Not having a safety net in your financial plan is akin to walking into a COVID isolation ward without a mask on. Here are the two broad aspects of contingency planning one needs to take care of.
Emergency corpus: The first and the foremost
A sufficient emergency corpus is the first element of your safety net. Look to have a few layers of your emergency fund. Start by keeping some cash at home, some amount in a savings bank account or sweep-in fixed deposit and then finally some in liquid funds. Many people usually restrict themselves to liquid or ultra-short-duration funds for their emergency fund. The recent winding-up of Franklin Templeton's six schemes highlights the importance of why one should have a layered safety net.
How much emergency corpus is good enough?
General wisdom on personal finance advocates having an emergency fund equal to at least six months of expenses. However, one should consider that as the minimum and you may need more cushion for your emergencies. First-hand pandemic experience might induce people to rethink this six-month rule of thumb. Here are some variables that should help you come to a reasonable figure:
- Families with a single source of income must maintain a larger emergency corpus as compared to those that have more than one source of income or earning member.
- Look back to figure out how smooth and predictable your monthly expenses have been in the last couple of years. If they've been fairly variable, for example, due to some health issues of a family member or some other reason, you need a bigger buffer.
- Do you have debt obligations which you need to service with heavy EMIs? During the pandemic, the government provided a moratorium but it's not every time that you may get a reprieve from EMIs. Your emergency corpus can help you keep them running if your income dries up temporarily. Therefore, look to have enough of it.
- Don't be concerned about generating returns from your emergency corpus rather prioritise surety, stability and safety over returns. Investing in products with steady but low performance numbers is fine as long as they manage to give you enough surety.
Insurance: A necessity, not a prerogative
If you thought you can get by without having health or life insurance, the pandemic should be your wake-up call. You should focus on planning for such low-probability but high-impact risks which can derail your investment plan. A single health emergency can eat away into years of disciplined savings in no time. The hospitalisation expenses for COVID care in a private healthcare facility could be pretty high, ranging from thousands to even lakhs of rupees.
Many people argue about the need of insurance if they have sufficiently large investment reserves. Now that's a false comfort. A big health expenditure can instantly deplete it and it won't be easy to replenish it quickly, leaving you quite vulnerable. Medical insurance is designed to cover for such contingencies year after year at a fraction of these costs. So, don't mistake any such corpus as a substitute to medical insurance.
Do not solely rely on employer-provided health insurance either. While employed, you might be able to seek comfort in it, but consider a situation like March 2020, wherein the lockdown resulted in job loss for many. This was a double whammy for the ones affected: a loss of health cover as well as income.
So don't just pay lip service to having health insurance. Don't blindly renew it each year but rather periodically review it and make any adjustments. If you have an individual health cover, do ensure that it is sufficiently large. The coverage should be rooted in reality to provide for a few weeks' hospitalisation, at the very least.