Have you ever needed a lump sum of cash, to take care of a financial emergency? That’s what credit cards are for, right? Wrong.
If you have to take out a short-term loan to pay for an emergency, you are going to pay a whole lot more for that emergency than what it actually costs, simply because of the high interest rates that are charged on short-term loans. In South Africa, interest on credit cards can easily exceed 20%. This could turn a R50 000 emergency into a R60 000 emergency, if you pay it off over a year.
A very low proportion of South Africans have cash readily available to pay for an emergency event. Typically they would have to take on debt, or liquidate long-term investments in order to be able to pay. Neither of these options are ideal.
I insist that every single one of my clients has a rainy day fund. It should take preference over any other type of saving, as emergencies can happen at any time. Thus it is essential to set it up as quickly as possible. The minimum aim of the fund is to contain one month’s worth (ideally three months’ worth) of expenses, giving you leeway in the event of an emergency.
This fund should fulfil a number of criteria, the most import of which are:
1. It should be conservative
When you want your money it should all be there, plus some interest. So it should either be invested in something like a money market account or an income fund. The Sharenet BCI Income Plus fund is my favourite for this purpose.
The reason why I suggest using a conservative fund is because the fluctuations in capital value are minimal in this risk profile. Ideally what you are after is a portfolio with a high likelihood of growing your capital without losing any, even over the short term. More aggressive portfolios may deliver better returns over the long term, but you may lose capital in the short term. Investing your rainy day savings into a portfolio which is too aggressive could see you lose money if you need to withdraw funds when the markets are performing poorly.
2. It should be liquid
In the event of an emergency, you need access to your money. Thus you should be able to access your funds in no less than a week. For this specific purpose I recommend a credit card. This allows you to pay for the obligation immediately on credit, then request your funds from your investment account and pay your credit card off, within the interest-free window (normally 28-60 days).
3. It should keep track with inflation
Inflation in South Africa is currently around 5%. Your fund should, after all fees, seek to at least match this figure.
4. It should not be invested in your bank account or 32-day call account.
Most banks offer basic savings accounts or fixed deposit savings options, but these yield inferior returns to most money market or income funds, and they impose penalties should you wish to withdraw your funds early. It makes little sense to use a vehicle like this for your emergency savings.
Setting up a fund is simple. You can contribute to it on a monthly basis via debit orders or simply contribute a lump sum if you already have the money saved. You can stop contributing at any time and access your money at any point in time, should you need to.
Even if you have more than three months’ worth of expenses invested elsewhere, allocating money towards a fund with a specific mandate will allow you to better manage your risk. Having to sell a portion of your share portfolio, Krugerands or Bitcoin is not something that you want to do, as you will reduce your long-term gains on these investments. Setting up a dedicated rainy day fund is the smart way to manage your risk.
If you wish to further discuss how to set up your own rainy day fund, please contact us.
Ricki specializes in the field of wealth management with a focus on holistic financial planning. He has a keen interest in the investment fields of property, technology, precious metals and cryptocurrencies. Ricki also holds a Masters degree in Science from the University of Stellenbosch.