Why an emergency fund is so important

One of the most fascinating animals I have come across in my life, is the northern short-tailed shrew. It has to be one of the cutest little animals to walk the planet. It’s not its looks that makes it so fascinating, however, but rather its “saving habits”, or more specifically, its “emergency fund”.  Their primary food source is insect larvae, but what I didn’t know, is that their saliva actually contains a type of venom that paralyses their prey. This venom places the prey in a comatose state, after which they drag it to their nest for later consumption. Because they don’t know if their current circumstances will continue to guarantee the availability of food in the near future, they can keep their sedated prey alive for days, and even weeks, if required. If the prey wakes up before to the shrew is ready, they simply bite it again for the prey to return back to its beauty sleep.

As human beings, we are facing the same uncertainty, and I would like to emphasise the word uncertainty, as Covid-19 is the perfect example of the type of uncertainty I am referring to. While many people have lost their jobs, there are also countless others who are still employed, but due to current circumstances, they are either only earning a fraction of their usual salary, or no salary at all. Yes, emergency measures have been put in place in the form of TERS/UIF during Covid-19, and in the form of standard UIF outside the scope of Covid-19, but the chances of these individuals actually earning their full usual salary, even with such measures in place, are fairly slim.

Contrary to the shrew’s method of preservation, luckily, we don’t have to make use of venom to protect ourselves against uncertainty. The primary purpose of an emergency fund is to cover your expenses for a period of at least six months in case of your retrenchment, dismissal, or any other situation that can prevent you from earning an income. In other words, its a fund established for the purpose of ensuring that your expenses are covered for a certain period, until such time as you can return to your full income generating ability.

How are these funds invested?

Cash related to an emergency fund is usually saved in a savings account, or in a money market-linked account at a bank. It is imperative that these funds are protected against market volatility, and they should (preferably) be available at short notice, which makes the abovementioned products ideal for this purpose. Growth is earned in the form of interest and your capital is protected against market volatility. It is important to note that interest rates between different banks and between different products, differ.

While a fixed deposit account or a notice deposit account may offer you a higher interest rate, these products may not necessarily be the best vehicle to use for your emergency fund. The funds won’t be accessible on short notice, without paying additional penalties for the early release of such funds before its maturity date, which in turn, may have a negative impact on the growth earned. Do your homework to  choose the right product, and be sure to compare the same type of product from various banks or investment companies, before you decide.

How do I get started?

Not unlike the shrew’s prey, an emergency fund is something that needs to stay “alive”. It has to be monitored and revised on a regular basis to ensure that it keeps up with your circumstances, and stays that way. Probably the first and most important step, is to compile a comprehensive budget outlining your monthly income and expenses. For more information, feel free to read my article entitled A budget is not a once-off process, for a step-by-step guide on how to compile your budget. This will also give you an indication of your spending habits, and will help you to cut back on unnecessary spending. Once you can see your expenses on paper, you will be able to calculate how much you will need for your emergency fund.

Also consider price inreases. If you are starting with this process relatively late in the year, its important to consider the fact that medical aid contributions and electricity costs, for example, increase annually, and also that your municipal accounts may vary from month to month, depending on factors such as water consumption, electricity use, etc. Not unlike a comprehensive financial plan, your “paralysed prey” or emergency fund also has to be monitored and adjusted to compensate for any unexpected shortages that may occur in the future.

The next step would be to determine how you will be funding your emergency fund. If you already have the capital available, the process is relatively simple in that you invest it in the product you have chosen. If you don’t have the capital readily available, you will have to work this into your budget through regular contributions. Do not underestimate the importance of an emergency fund. An emergency fund shouldn’t be an investment that you simply dump whatever’s left of your income into, at the end of each month. Rather set up a debit order or a regular withdrawal from your bank account if you can, so that a fixed amount can be allocated to your emergency fund every month. Of course you can transfer any surplus you might have at the end of the month to your emergency fund as well to get to your initial target quicker, but only as long as such contributions are made in addition to your fixed monthly contributions, and they are not the primary source of funding for your emergency fund.

It is extremely important that you understand that an emergency fund forms part of a comprehensive financial plan. It is an investment goal in its own right and shouldn’t be confused or combined with any other investment saving goals, such as saving for an overseas holiday, retirement or a new car. If you feel overwhelmed, however, or cannot see any room for saving towards an emergency fund in your current budget, it is always advisable to consult a professional to assist you, and who can assess your financial situation holistically.


The opinions expressed in this blog are the opinions of the writer and not necessarily those of PSG. These opinions do not constitute advice.  This is intended as general information and does not form part of any financial, tax, legal or investment related advice. Although the utmost care has been taken in the research and preparation of this blog, no responsibility can be taken for actions taken based on the information contained in this blog. Since individual needs and risk profiles differ, it is always advisable to consult a qualified financial adviser before taking action.

 

Schalk Louw

As Portfolio Manager at PSG Wealth Old Oak and with over 20 years’ experience in the investment industry, Schalk has consistently delivered solid returns to his clients and has certainly become one of South Africa’s most well-known strategists. He started his career in 1994 at the stockbroking company, Huysamer Stals (later ABN Amro). He joined SMK Securities in 1997, (later became BoE Personal Stockbrokers) and was later appointed as director and branch manager. In 2001 he co-founded Contego Asset Management and managed the company as CEO up to March 2014, after which he joined PSG Wealth Old Oak. Schalk has also become a regular household name with investors, with his reports being published in many of the national press. He completed his MBA in 2008.

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