Creating an Emergency Reserve: A Practical Guide

A contingency reserve, including the cash you keep at home, acts as a form of self-insurance to protect your family’s well-being during a crisis. Recognizing this purpose can help you appreciate the necessity of creating such a fund.

A contingency reserve is designed to cover expenses during uncertain times and unexpected costs during normal periods. Previously, we discussed the best places to park a contingency reserve. To recap, it’s preferable to keep these funds in liquid investments with no downside risk, typically interest-bearing instruments. Additionally, protecting the inflation-adjusted value of your contingency reserve is ideal. If that’s not possible, strive to protect at least the nominal value of the reserve. In this article, we will explore why credit cards cannot always serve as a contingency reserve and why keeping some cash at home is beneficial.

The Limitations of Relying on Credit Cards

In today’s digital age, many people rely on electronic money — such as UPI payments and credit cards — for their expenses. Some may argue that credit cards can serve as a contingency reserve. However, this assumption has several flaws. If your credit limit is maxed out or insufficient to cover emergency expenses due to regular use for lifestyle purchases, it may not be reliable in a crisis. You might consider keeping one credit card solely for emergencies, but infrequent use can lead to the credit card company reducing your limit on that card.

Maintaining a separate contingency reserve is the optimal strategy to handle unexpected expenses, particularly if your income stream is volatile.

The Case for Keeping Cash at Home

Given the prevalence of electronic money, one might question the necessity of keeping cash at home. The answer largely depends on your location. If you live in an area prone to natural disasters such as flash floods or tsunamis, having cash at home can be crucial. When such calamities occur, electricity, Internet service, and phone connections may be down for a period. Without these services, electronic transactions become impossible, and cash may be the only way to pay for essential items like food and water.

Overcoming the Saliency Bias

Many people hesitate to maintain a contingency reserve because they feel the money does not earn optimal returns. This concern is known as saliency bias. It involves focusing on the idle money in your home or savings account, compared to, for example, the loss-making stocks in your trading account. Instead of viewing your contingency reserve as unproductive, consider it as self-insurance that protects your family’s well-being during a crisis. This perspective can help you appreciate the importance of maintaining such a fund.

In summary, a contingency reserve is a crucial part of financial planning. It provides a safety net during uncertain times and unexpected events. While credit cards and electronic payments offer convenience, they are not always reliable in emergencies. Keeping some cash at home ensures you can handle essentials even when digital systems fail. By viewing your contingency reserve as a form of self-insurance, you can better appreciate its role in safeguarding your family’s future.

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