Creating an emergency fund

If you are starting off this journey, chances are that you will not have a readily-available fund that is essential to provide some resource slack we had talked about. You must systematically build it. There are two reasons for having this.

Firstly, it serves as a cash reserve when there is a sudden need for money. We have already encountered an example case where you had to buy a laptop. To a lesser extent it can also address any overconsumption in any of the spend-buckets in reality. A negative number on a spreadsheet means nothing. Having no reserve to compensate for that lack of money is a reality check. Then again, you already know that very well.

Secondly, it is a fallback in case your income sources dry up. The pandemic has seen many businesses shut shop and many people lose their jobs. In case of such a misfortune, you might be able to make a budget plan that only has the non-negotiable spend-buckets and none of the other ones and survive until you are able to tap into another source of income.

You might ask the question—what should be the size of the fund? Well, there is no good answer to that. As a thumb rule people set aside anywhere between 6 and 12 months of their monthly income. In my opinion, you can do a much better estimate by treating this objectively. Your base emergency fund should be equal to or greater than the non-negotiable spend-bucket for an entire year. Remember, I had asked you to compute minimum survival cost and write down the lifestyle associated with it. Well, you should be adopting that lifestyle in case of a financial emergency.

Consider this as a save-bucket. You can name it Base Emergency Fund in your budget spreadsheet and set aside a portion of your income to build this up. Keep this as hard cash in your savings account. This is not an investment—i.e, you are not trying to earn money using this money. Depending on your income and your lifestyle, it may take you anywhere from 6 months to 3 years to build this fund.

Create a save-bucket for Base Emergency Fund

This amount may not be enough to tackle simultaneous multiple misfortunes. Loss of job, medical needs, supporting a friend or a relative in crisis, etc. If you foresee such scenarios, you can create another save-bucket and do the same exercise. The idea is that you are creating these "top-ups" over the base fund. You must make sure that the base fund is fully ready before you plan a "top-up".

Having an insurance

You should have a separate medical insurance irrespective of whether your employer provides you with one. This is necessary because you would want it to be independent of your current job. There was one time when a friend fell off his bike and fractured his leg. He had resigned from his previous job and had a couple of weeks to go before he would join another one. He had to bear the cost from his own pocket. Although this was not a severe scenario, it merely shows that there can be pockets where a group medical insurance policy might not be in effect. Also, your employer's policy might not include all the members of your family. This will be reflected in one of the spend-bucket in your budget plan—either as a standalone entry or as part of a health or medicine-related bucket.

If you have dependents, you should also consider taking a term insurance. You will be betting against your life but consider it as a hedging. It will act as a cushion for some amount of time for your family in case you are not around any more. There is no set amount to for what should be the sum insured but keeping it at 2 times of your annual income might be a good starting point. Later, depending on your liabilities, you might want to increase your sum insured by topping up your existing policy or by buying additional policies. Just like the medical insurance, this too would be reflected as a spend-bucket in your budget plan.

In India, a lot of people are lured into endowment plans. Often they are not very good options. They combine a medical insurance, a term insurance and some sort of an assured return should you survive till a certain age. You may have one. Your parents might have bought one for you because some agent-uncle had convinced him that it is good. To that I would say, analyse for yourself. Wait until you learn about time value of money. You would be able to decouple the medical insurance, term insurance and the assured-return part. You will be able to arrive a much more authentic conclusion if it makes sense to pay separately for medical and term insurance and invest the difference of your endowment premium and the cost of these insurances in different instruments. Does it make sense to continue the endowment plan? Should you treat your past payments as sunk costs and move on with a different plan? This is not a very simple thing to explain at this stage.

Now it is time to explain some theories and models that will help you in designing an investment plan.