All of us lead a relatively regular routine with expectations that our lives will remain unchanged. However, problems tend to appear unexpectedly at the most inopportune times and when this happens we may have to depend on our emergency funds.
An emergency fund, as the name suggests, is a sum of money collected for emergency use or when something unexpected happens, such as the loss of a job, having medical issues, becoming a caregiver for family members and being affected by natural disasters.
Here are five reasons why you need an emergency fund.
1) Safety net from the risk of investing
Emergency funds are also necessary for retail investors as a form of safety net for when your investments do not meet the expected ROI. It is particularly important for retail investors who tend to invest in high-risk investments because the chance of failure or the chance of losing your principal investment is higher than low-risk investment options.
Always keep in mind the most important rule: ‘Never invest money that you can’t afford to lose’. Once you invest money in any option, the chances of losing a portion of your money are never zero, no matter how unlikely it may be.
2) Term to maturity of investments
The maturity date, which refers to the time required for a bond or fund to mature and the principal to be paid back to the investors, varies based on the chosen type of investment.
Long-term or short-term bonds and securities have a fixed maturity date, as compared to other forms of investments like a unit trust fund, stocks, savings or fixed deposit account.
A maturity date is an important factor that determines an investor’s investment horizon, which is the amount of time an investor is willing to stay invested in an investment option.
The maturity date also allows you to plan and align your investment horizon to your investment goals, for example: buying a house in 10 years, or planning for retirement in 40 years.
However, emergencies may catch you out by surprise. Imagine a scenario where you have invested in bonds and securities but you do not have enough cash on hand. You likely have to withdraw funds from your investments that have yet to fully mature and incur a loss while also losing the momentum of the investment and dividend payout.
Emergency funds are essential so that you will not jeopardise your ROI by withdrawing before your securities have matured. Make sure to plan for any unexpected changes in your life by having an easy-to-reach cash pool when the need arises.
3) Illiquid nature of certain types of investments
Another reason why emergency funds are important is that most investment options are relatively illiquid, meaning that it is difficult to convert them into cash while retaining its cash value. Stocks, bonds and other assets have volatile values which change from time to time depending on the market conditions.
The best time to sell stocks and other securities to make a profit depends on the market conditions, causing demand to soar and the price of stocks to increase. It is in an investor’s best interest to sell at a higher price than the previous bought. It is fine as long as you have the patience to wait and sell when the demand is high.
The problem is that you might be handed the short end of the stick and having too many illiquid investments may not work out well especially if an emergency were to happen. Without enough cash on hand, you will be forced to sell your stocks and other securities at a lower price, incurring a significant loss.
4) The volatility of the securities market
Investments and securities are volatile, some more so than others. That means that it is near impossible to predict how it will perform once you have decided to invest. Certain securities are more volatile in value compared to others, and this contributes to the uncertainty of how well or badly they may perform. Do keep in mind that securities with high volatility tend to have the highest potential return compared to low-volatility securities, so check your investment appetite and invest accordingly.
Volatility is also a measurement of fear in the market. The COVID-19 pandemic has been a lesson on market volatility as many industries, mainly retail, airlines and tourism industry, plummeted, with their market shares yet to fully recover.
Emergency funds are important because they can help mitigate investing fears. With a sufficient amount within your emergency funds, it is still possible to keep an optimistic view, while stock prices steadily improve as the economy slowly opens. Having an emergency fund helps you to ‘ride out the storm’ as you will have a sufficient amount of cash to account for your living expenses.
5) Cushion investing mistakes
Hindsight is 20/20 when it comes to investing. It is not possible to predict how well an investment will perform. Accept the fact that everyone, including you, will make mistakes when investing. The important part is that you understand at what point to cut your losses to avoid losing even more money.
Let’s say that you invested in the wrong stocks at the wrong time and you had to cut your losses. At times, you might have waited too long to do so, and your decision may cost you your finances.
An Emergency fund can act as a cushion in case you do make any investing mistakes: investing at the wrong time, failing to diversify your portfolio, or if your high-risk investments have backfired spectacularly and so on.
In investing, it is impossible to avoid making mistakes, especially if you are a new retail investor. At the same time, you should not be ashamed of your mistakes. Rather, it is an opportunity to learn from your experience. The emergency funds that you have set up will help put you back on your feet as you work to fix your mistakes and be much wiser from the experience.
Emergency funds are important to you as an individual when faced with life-changing events, however, they can also serve their purpose to you as a retail investor. Emergency funds can help in the form of a barrier, so that you may be prepared for any shortcomings due to the volatility and risk when investing. Build your emergency fund, and it will serve you when you need it the most.
Are you ready to invest with Ethis? Consider long-term investment through Ethis Malaysia’s equity crowdfunding (ECF) platform and support Malaysia’s shariah-compliant SME or start-ups. Also consider short-term investing in diverse SME projects on Ethis Indonesia’s peer-to-peer crowdfunding (P2P) platform today.