Contingency reserve is set up to meet expenses during uncertain times and unexpected expenses during normal times. Previously, we discussed where to park contingency reserve. To recap, it is preferable to keep contingency reserve in investments that are liquid with no downside risk. That means investing in interest-bearing instruments. Also, it is best if you can protect the inflation-adjusted value of contingency reserve. If not, you must strive to protect at least the nominal value of the reserve. Here, we discuss why credit cards cannot always act as contingency reserve and why having some cash at home is optimal.

Natural factors

Like many, you probably use electronic money — UPI payments and credit cards — to meet expenses. Some argue credit cards can act as contingency reserve. But what if your credit limit is full or not enough to meet a contingency payment because you use them for lifestyle expenses? If you have multiple credit cards, you may argue about keeping one credit card exclusively for meeting such expenses. But such expenses are not frequent. So, if you do not use credit card often, chances are the credit card issuing company may reduce credit limit on that card. Maintaining a separate contingency reserve is optimal to meet unexpected expenses, especially if income stream is volatile.

This brings us to the next argument. In modern world where electronic money is preferred, why maintain some cash at home? The answer depends on where you live. Is your city prone to natural disasters such as flash floods and tsunami? If so, keeping some cash at home may help. The reason is simple. When natural calamities happen (uncertain times), expect the electricity, Internet service and phone connections to be down for a while. How then would you pay for essentials, including food?

Conclusion

For many, the feeling money does not earn optimal returns is the primary issue associated with maintaining a contingency reserve. This is called saliency bias. You focus on idle money at home or the contingency reserve in your savings account, compared with, say, the loss-making stocks you hold in your trading account for a long time. Instead, think of contingency reserve including the cash at home as a self-insurance to protect your family’s well-being during crisis. That may help in you appreciating the need for such a fund.

The author offers training programmes for individuals to manage their personal investments

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