Why you must have a Contingency fund

In the last post I wrote about the need of an Emergency fund and ways to create it. This post is about Contingency fund – what is it , is there a need to have it and how can we create one.Many people confuse an Emergency fund with a Contingency fund but, as we shall see here, these two are fundamentally different.

So what is a “contingency” ? Webster’s dictionary defines it as ” dependence on an uncertain occurrence or condition”. In other words it is something that may or may not happen, but is important enough for us to be prepared for it. The immediate example and an extreme type of contingency is death. Now, you will typically cater to such a contingency through a Term insurance. Other forms of contingency can be covered by other types of insurances – for example health insurance, accidental insurance, critical illness insurance and professional liability insurance, to name a few.

So, if you can cover most of the contingencies by insurance why have a separate contingency fund? Two reasons – firstly, while to more important contingencies do need to be covered through insurance, if you stretch it for all situations then the insurance premiums will get prohibitively expensive. It is better to have a common fund as the probability of multiple contingencies striking at the same time is practically zero. Secondly, even if you are fine with the expense of the premiums, we simply do not have insurance covers available for all contingencies.

Some examples of the kind of contingencies that can happen will make this clear:-

  • A person loses his job and is unable to get one within 6 months.
  • The wife takes a 6 month break for child-birth, but is unable to join work for another 6 months.
  • A sudden illness in the family requires much more than the cover of health insurance.
  • A long standing Client terminates the contract and this results in serious cash flow problems.
  • An unexpected school/college trip for children turns out to be quite expensive.

Now that we have seen why we need to have a Contingency fund, let us look at how much we should be having in it. The good thing is we only need to plan for the maximum contingency and not cumulatively for all of them. In most cases this will be equivalent to 6 -8 months of your monthly expenses including EMI, in the event of a job loss. I would say take 8 months to be on the safe side. Assuming you spend 50 K each month we are talking about 4 lacs.

How should we create a Contingency fund. Well, if you are following the blog carefully and have established your 3 portfolios in Debt, MF and Stocks then you really do not need to do anything. You simply keep investing in the 3 portfolios and when the contingency does occur, use the most appropriate portfolio to take out some money. The only thing you need to do is to take the Contingency fund amount into consideration with your goals when you decide on investment levels.

Once you have done the above, you have a Contingency fund inbuilt in your portfolio, that you can use any time you need to. With the relevant insurances in place also, you are now protected against most eventualities that life can throw at you.

May not be financial nirvana yet, but certainly a good state to be in.

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