A journey of a thousand miles begins with a single step.
Welcome to this exciting journey on achieving your Financial Independence. Let us try to cover the first mile in Financial Planning in this post. I sure want to keep the posts shorter to make an interesting fast read but this post will consume some 5 minutes at least to wade through, no more. Just keep going – I guarantee you will like it!
Financial Planing is the process of meeting one’s life goals through the proper management of personal finances. As like any project/undertaking Financial Planning follows the Deming’s PDCA cycle [Plan–Do-Check-Act] . We will discuss in detail about creating a Financial Plan in this blog.
- Create a detailed Financial plan
- Execute the Financial Plan
- Monitor your progress at least once a year (recommended every 6 months) if you are in the right track. Also identify any changes in personal/financial life – Eg: New dependents, a huge change in your take-home pay, job loss etc. and any changes in goals (you want a larger home or a car)
- Make changes to your Financial plan to realign your plan to your goals
Creating a Comprehesive Financial Plan: Start by answering the following:
- Where am I today (How much assets and liabilities do I have)
- Where do I want to go (How much will I need for my future needs: Include eveything from Family expenses in future, Kids’ education, Buying a Car, Expensive Vacations, Entrepreneurship dream project cost/opportunity cost, Kids’ marriage expenses and most importantly your own retirement and lastly how should my wealth be distributed posthumous)
- The ‘How do I get there’ is really your Financial Plan
Estimating future expenses: Once you have an exhaustive list of your goals you need to estimate their future costs. Do remember that Inflation eats away your buying power. A Balcony/Box ticket for a movie cost Rs. 40 about a decade ago however you almost cannot find a ticket priced below Rs. 100 (and most likely pushing Rs. 150) in most of the multiplexes today. Hence in estimating future expenses you need to ensure that your expenses are adjusted for inflation. A long-term inflation rate of 6% to 7% is acceptable but estimate it on the higher side to be conservative. The table below lists the impact of inflation on a few things.
|Rate of Inflation||2001||2011||2031||2041|
|Movie Ticket||11.6%||INR 40||INR 120||INR 1,076||INR 3,226|
|College Tuition Expense||6.00%||–||INR 2,000,000||INR 6,414,271||INR 11,486,982|
|Monthly Expense||6.00%||–||INR 25,000||INR 80,178||INR 143,587|
Not all expense items change at the same pace as Inflation but this is a very decent estimate of your future cost. Once you have identified your current cash flows and have estimated future expenses adjusted for inflation you have to identify how to invest your money.
Investing your money:
There is definitely no magic wand here (and we will cover several parts of this section, mentioned in italics, in separate posts in the coming days). Depending on one’s life goals the corpus one needs to invest and the returns one needs vary greatly for every individual. There is no one-size-fits-all solution. However what I am proposing here is a brief outline of how to go about investing.
Empirical studies have shown 2 things:
1) Equity markets have outperformed Debt markets over the long run
2) The asset allocation between Equity and Debt plays a far more significant role in building wealth than just security selection.
Investing in Equities is not everyone’s cup of tea. Hence the easiest way to take part in Equities is via Mutual Funds. Just to get through making a Financial Plan let’s assume here that you are able to pick the right Mutual Fund schemes. If you have had one or two instances of your schemes faring worse (i.e the Mutual Fund scheme fared poorer than the market) do not hate MFs all together.
A mix of equity and debt is recommended across age groups with the tilt towards debt becoming higher as you grow older. This way a steady stream of income will bear the shocks of the equity portfolio. Rule of thumb here: The allocation to debt should be equal to your age. Thus a larger corpus is allocated to debt as you grow older. The main things to notice when investing in Debt instruments are:
Returns: If the return offered is too good to be true, chances are it is. When Bank FDs quote at 10% and some entity offers 11% it may appear reasonable but if someone guarantees you 18% return it is most likely a Ponzi scheme or a bogus scheme
Liquidity – Though there is a risk at maturity that you may not be able to invest the proceeds at the same higher rate as before, shorter maturity debt (say, 2 – 4 years) carry the element of liquidity so you may choose to utilize the maturity proceeds differently.
Planning for the inevitable:
A) Term Insurance: The untimely death of the earning member of a family will expose one’s heirs to a lot of uncertainty. Apart from the emotional trauma from the loss of a loved one they may also be in for a financial trauma if there is no proper planning on one’s part. There may be loans outstanding that need to be settled. Future income/cash flows could have been planned for further investment to meet financial goals, which will now stop. Human Life is precious and has infinite value, no doubt. However human life needs to be insured for an amount, the thumb rule being 7-10 times of one’s annual income, so the planned goals can be met in the event of their untimely demise. There are a whole lot of variants of life insurance. But the most cost effective one is buying a Term Insurance. Simply put, you pay a premium every year (usually) through the life of the policy. In the case of an unfortunate event the Sum Assured is paid to the insured’s nominee. If the insured survives the duration of the policy the policy ceases to exist. There are tons of other variants that return some portion of your investment if you outlive the policy. Though such plans appear to be a better option very simple calculations will clearly show that Term Insurance is the best option. So, go for a Term Insurance. Having a Term Insurance is by far the most important step in your overall financial planning.
B) Health Insurance: The Health care costs are soaring every year. Having a Health Insurance pay for your treatment is the best way to mitigate the financial impact of an illness. Health Insurance and a Critical Care Illness plan are a must
C) Unforeseen risks: Murphy’s laws are always at work. A job loss is an unforeseen risk. A sudden business risk or a business opportunity may materialize and you may need some urgent funds to deploy. For such events a contingency fund ~ 6 months of your monthly expenses ~ should be created and kept liquid (Eg: Short term debt funds, Savings account etc.).
Taxation and Estate: The tax code of any country gives you certain concessions on how different classes of income can to be treated and what taxes need to be paid. Your income can be made tax efficient so more of your income stays in your hand within the legal ambit.
Estate planning is best understood as a process of making proper arrangement for the protection and preservation of a person’s total assets for the benefit of his or her family and loved ones. Creating a Will detailing how to distribute/utilize one’s assets will ensure that there is no direct conflict after the lifetime of the maker of the will
Putting it all together – Here is our Financial Planning in a nutshell:
- Take stock of your current assets and liabilities
- Define what you need to achieve financially over the next few decades including during your retirement
- Decide how to invest your money in achieving those goals. A mix of equity and debt is recommended across age groups with the tilt towards debt becoming higher as you grow older.
- Make sure you have adequate Term insurance – This is by far the most important step in your overall financial planning. Well, even if you don’t have a plan or never intend to create one just ensure that you have a Term Insurance policy in place so your family is supported.
- Make sure that you have a Health Insurance in addition to what your employer provides
- Create a contingency fund to meet any emergency. If you happen to exhaust the fund rebuild it!
- Ensure you optimally utilize all the tax concessions you may be eligible for
- Plan for the proper transfer of your estate. It is never too early to make your Will.
************ Thus begins our journey to Financial independence ************
So, in your opinion what is the most important take away from this entire post? Share them through your comments below.