Emergency Fund 2.0: A Risk-Based Framework For Today’s Investors

Emergency funds provide financial protection for essential expenses when faced with unexpected circumstances like losing work or in case of medical emergencies. The contingency plan functions as a financial buffer which protects your investments while maintaining your objectives and keeping your mental state stable during times of uncertainty.

Traditionally, investors used to maintain 3 to 6 months of essential expenses as an emergency fund.

“The logic was simple - most individuals would find alternate employment within that timeframe, and emergency medical costs would be partly covered by insurance. However, with the days passing, reality became more complex. Nowadays, a significant portion of monthly income is committed to fixed obligations such as home loan EMIs, vehicle loans, school fees, insurance premiums, and utility expenses. Unlike discretionary spending, these cannot be paused during income disruption. As a result, the base level of essential expenses itself has expanded,” says Arjun Guha Thakurta, Executive Director, Anand Rathi Wealth.

For instance, imagine a 35-year-old family man who started his professional career at 23. At that time, his expenses would have been minimal, he might have been living without dependents, and carried little to no financial liabilities. His monthly outflows may have been limited to personal lifestyle expenses, commuting, and small discretionary spending.

“In such a scenario, maintaining three months of expenses as an emergency fund may have been more than sufficient. Fast forward twelve years, and the financial landscape looks very different. Today, he might be having a home loan EMI, paying vehicle instalments, funding school fees, maintaining insurance policies, supporting ageing parents, and managing household utilities. His responsibilities have multiplied, and so has his fixed cost structure. The risk exposure is no longer limited to his own survival expenses; it extends to the financial security of an entire family,” says Thakurta.

Additionally, inflation further compounds the challenge. Over the past few years, the cost of healthcare, rent, and services has substantially increased. What covered six months of expenses 10 or 12 years ago may now barely sustain 2 to 3 months at current prices. If emergency reserves are not periodically reviewed and adjusted, their real protective value decreases.

“A more practical framework for investors would be following a risk-based rather than a rule-based approach. For dual-income households with stable employment and manageable liabilities, six months of essential expenses can still serve as a foundational safety net. Single-income families, individuals having large EMIs, or those with dependents should consider maintaining closer to eight or nine months of essential expenses,” says Thakurta.

This provides a suitable defence against financial emergencies which extend past the estimated duration of income interruptions. Self-employed professionals, together with freelancers, start-up workers, commission-based staff and employees from seasonal industries need to build their emergency fund between nine and twelve months of expenses.

Moreover, while defining the emergency corpus, individuals should consider essential expenses, such as home loan or rent, other EMIs, utilities, insurance premiums, school or dependent-related expenses, and basic health/medical care outflows. Investors can consider keeping this contingency corpus in highly liquid instruments such as liquid funds, fixed deposits or short-duration funds. If one is in a higher tax bracket, one can consider arbitrage funds as well for tax efficiency.