It is common knowledge that an emergency fund can help in any kind of contingencies – be it medical, job loss, sudden repairs, etc. It is not for earning returns neither is it for planned expenses. It should be as liquid as possible and safety of capital is important. But there is also another perspective to this, which many people do not think of. An emergency fund protects your long-term financial assets. Let me give you a real-life example.
A client, self-employed, was forced to sell Rs.55 lakh worth of his equity mutual funds during Covid. His wedding business was badly affected during the lock down and most of his working capital was stuck. With severe liquidity crunch, dried up revenue and the uncertainty about when the lock-down will be lifted, he had to sell a big chunk of his equity funds. He needed money for few months not just to run his household but pay salaries to his staff in the difficult time.
Ideally, it is not prudent to dip into your long-term investment bucket for short term requirements. This is one of the fundamental principles of financial planning – keep your short and long-term investment buckets separate. Long term investments in growth assets like equity need time to grow and compound. This is where an emergency fund can come in handy. It helps to prevent unplanned liquidations. In a falling market, a distress sale can lead to more losses when the value of your investments is already down. An emergency fund thus ensures that your long-term equity bucket continues to grow and is not disrupted in the short term.
So, maintain one and keep it separate, do not use it for any other aspirational purposes. Ensure to replenish it when utilised in any emergency.