Phailin was one of the most powerful cyclones to hit India in recent times. Raging winds and rain plundered the eastern coast. Over 26 lakh trees lay flattened. However, the palm trees survived most of the carnage. The palm’s flexibility— its sturdy trunk can bend over 50 degrees without snapping— enabled it to bear the disaster far better than other trees.
Similar flexibility in your finances is also critical in emergencies like accidents, illnesses or job loss. The flexibility determines if you will achieve your life goals with certainty. Flexibility can be looked at from two perspectives— assets and cash flows.
Flexibility in assets
Many of you have a large proportion of your portfolio in real estate, unlisted stocks and bonds with long lock-ins, art or antiques. These assets cannot be easily converted into cash. It may be difficult to find buyers at short notice, and even if you do, you may have to sell at a discount. They also carry a fair amount of risk, especially when markets are volatile. It is important to ensure that not more than half your portfolio is invested in illiquid assets.
Flexibility in cash flows
You can divide your cash flows into three categories—fixed, regular and discretionary. Fixed cash flows include expenses such as rent, EMIs, school fees and insurance premium. Regular cash flows include groceries, utilities, fuel, domestic help etc. The latter occur at a regular frequency, but the amounts may vary. One may be able to reduce these expenses if needed. Discretionary cash flows are expenses that can be dispensed with. These can include money spent on vacations, entertainment, eating out, shopping, donations etc.
The amount you hold in each category determines how flexible your cash flows are. A large proportion of your cash flows being either fixed or regular imposes rigidity and inflexibility. Reducing expenses to handle emergencies becomes difficult. On the other hand, if a large proportion of your cash flows are discretionary, then your cash flows are very flexible. Even if no income were to come in for a few months, you can manage easily for a longer time by reducing these expenses. Flexibility in cash flows enables better handling of a job loss.
With inflexible cash flows, if you suffer a job loss, your next job quickly needs to pay you the same income so that you can sustain your expenses. Further, you will hesitate to take risks with your job. Fewer loans improve the flexibility of your cash flow, so strive to reduce your debts while you are employed.
Having flexibility in both your cash flows and assets is desirable. If your assets are flexible and adequate, then you can manage even if your cash flows are inflexible. You can redeem these assets easily and sustain your expenses for longer. Thus if you suffer a job loss, you can take time to find the right job and not jump at the first opportunity that comes your way. Problems arise when both cash flows and assets are inflexible.
You should have an emergency fund to handle job losses. This fund should typically be sufficient to handle routine expenses for six months, and your annual fixed payments such as insurance premiums and school fees. The money can be invested in an ultra-short debt mutual fund, which offers you almost three times the return of your bank savings account.
The largest asset of all is you. In your working years, you are a money-making asset, since you provide the money for routine expenses and for funding your long-term goals. Banks lend you money on the basis of your earning potential, which you repay over time. Adequate life insurance covers all your liabilities, protecting your long-term goals and ensuring that the family’s routine expenses are met.
Illness or disability could put you out of work for long periods. You must put in place a healthy medical cover for you and your family. This will ensure that you do not dip into your personal funds for medical expenses. Disability and critical illness covers give you an additional lump sum, which help fund your routine expenses during the time you are away from work. Your health insurance can take care of your medical expenses.
If you have a home loan, insure yourself against job loss. These covers pay three EMIs in case you lose your job. They are usually available for five years and need to be renewed. The caveat is that the job loss must not be due to underperformance. These covers are usually bundled with mortgage insurance policies and are not available as standalone.
Job losses do not have to be stressful. Sometimes, they open up opportunities for you to pursue your passion. Building a retrenchment-proof financial plan ensures that you weather the storms in the short run and make the right career choices in the long run.
(The writer is Director, PeakAlpha Investment Services)