Don’t look for higher returns on emergency funds :: Business Line

We suggest you keep your emergency funds (the money that you set aside for medical emergency or to meet living expenses in case of loss of income) in a savings bank account.

But will you? Your preferred choice would be a short-term fixed deposit or a liquid fund, as they can earn higher return. There is nothing wrong with your choice, if you are aware of the associated risks. But many times, you might be suffering from a behavioural bias.

AVAILING DISCOUNTS

Suppose you can save Rs 250 on your grocery purchases of Rs 2,500. But you have to drive 5 km to the store that will accept your discount coupons. Will you avail the discount?

Chances are you will, unless the traffic is very dense or your favourite show is running on TV. Now, suppose you are offered Rs 250 discount on an LED TV that costs Rs 65,000. Will you drive 5 km to the store to avail the discount? Highly unlikely.

We typically look at the percentage saved and not the absolute savings. You save only 0.50 per cent on the TV compared to 10 per cent on the grocery purchases.

Now, your decision may not seem entirely rational, because percentages do not pay for your living expenses, absolute money does.

It is no different with your emergency fund. A fixed deposit with a bank will pay about 8 per cent whereas a savings bank account will fetch 5-6 per cent. Indeed, 2-3 percentage points higher return looks attractive.

But with this, you would have earned only about Rs 12,000 extra on your emergency fund of, say, Rs 4 lakh, before taxes and much less after taxes. And then, consider the associated hitches - you cannot withdraw your fixed deposit at an ATM. So, what will you do if you need emergency money?

INVESTMENT PORTFOLIO

In any case, have you checked your investment portfolio? Chances are you have more money in fixed deposits and less in equity.

And better yet, you forgot to renew one of your fixed deposits that matured 2 months ago! Have you calculated the returns that you gave up because of these decisions?

So, why then are you concerned about the lower returns on your emergency funds? When you created your portfolio, you had to consider several variables such as how much to save and your ability to take risk.

The risk of investing in equity was more apparent to you than the higher expected return it offered.

But with emergency funds, the choice is simply between two interest-bearing investments — savings account and fixed deposits or liquid funds. The loss in interest income is obvious, though not the associated risk.

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