Drought is a terrible situation of water shortage which many parts of our country face regularly. Most of us urban dwellers do not realise the severity of the situation as we are relatively cushioned by the civic amenities available to us. But we are much more likely to face drought situations in our personal finance. Since there will be no systemic cushions provided, we have to brace ourselves to avoid drought like situations in personal finance.
Take the example of the Negis. Their son is aspiring for an admission to a medical college. They are quite confident that he will get admission to a good college as he has been scoring well. But funding the education is giving them some sleepless nights. They had bought a small property in Noida some years back with the aim of using it for their son’s education. Unfortunately the property prices have fallen over last couple of years.
There are very few buyers and those that are in the market are offering very low rates compared to their expectations. There is no way they can postpone the goal, so they might have to settle for selling at a lower rate. That will leave them with a gap to meet the education requirement. In that case they will have to pull out some money from their other investments which they have earmarked for their retirement. So the education goal may end up impacting the retirement goal. They are facing a financial drought.
There could be other similar situations where lack of readily available cash could cause problems. Imagine a situation where a medical emergency requires you to pay upfront cash. While a medical insurance will help, there could still be problems. If the cashless payment does not get approved for some reason, the money will come only later. What do you do now when the cash needs to be paid in advance?
Or a situation where you need to be off work and have exhausted your paid leaves. Even being out of a job over some months is not an uncommon situation in present times. Most of these times there will be no inflow of income, but expenses will continue. These would be periods of financial drought.
If you think that credit cards can come to the rescue in these situations, think again. You might solve the momentary problem, but you will be paying heavy interest if you are not able to repay the card outstanding on the due date. You need to check if your cash flow will be regularised by the next due date of your card payment. Borrowing from banks is another way out. You may want to go for a personal loan. But the rates are usually too high.
Pulling out funds from investments which have been started for specific goals can be another immediate reaction. Withdrawal will impact the compounding effect that helps multiply your wealth over a long period of time. There might be penalties levied or tax implications on early withdrawals. If the withdrawal amount is not replenished, it might impact the possibility of achievement of the goal.
Some of the problems above can be addressed if there is a good contingency fund maintained. This fund should be created by layering method using instruments that can make available the cash immediately or at a very short notice. The first layer should be your savings account. Second layer should be savings account linked fixed deposits which can be accessed through the ATM anytime. And last layer should be liquid mutual funds.
The next thing that comes to mind is the quantum of the contingency fund. Ideally you should maintain about 3-6 months of expenses in this fund if you are in a job which is stable. If you work in an industry which has chances of bearing the brunt of slowdown of economy, you may increase this to about 12 months. With niche career specialisation, seniority and age, it gets more difficult to get a good placement in a bad market.
This too, calls for a higher allocation to contingency fund. Self employed people have erratic cashflow hence they need to maintain a higher level of liquidity; at least 12-18 months expense would be a good level. Your family structure will also impact your contingency money requirement. If you have a big family or if there are aged members who might need enhanced medical attention on a regular basis, the requirement increases.
Not all expenses need to be considered for arriving at the contingency figure. In tough times discretionary spending like eating out and entertainment will be cut down drastically. What needs to be included is expenses for running the house, EMIs, premiums for term insurance, health insurance, vehicle insurance and school fee.
To avoid being in a situation like the Negis you need to have an analysis of liquidity situation when you plan for your goal expenses. There needs to be a ‘Plan B’ in place to address such situations. While from a long term perspective it is good to have assets allocated to goals, as you near the goal, the portfolio should be analysed for liquidity. The funds need to move into assets which are less volatile and liquid, so that the goals are not compromised due to extraneous conditions.
Callous attitude towards environment makes a natural calamity (like a drought), more of a man-made calamity. Caring for the environment on a daily basis is the best way to conserve nature and avoid droughts. Likewise taking care of your money on a regular basis is the way to avoid liquidity crunch in your financial lives.
(Kiran Telang, is a Sebi registered investment adviser, Certified Financial Planner)
