Financial Planning

Over the last few years, terms like financial planning and personal finance have emerged as buzzwords of sorts. So what is financial planning?

Financial planning is a process through which an individual can chart a roadmap to meet expected and unexpected needs in life. The intention is to take necessary steps to ensure that the individual is equipped to accomplish financially what he has set out to achieve and is prepared to deal with contingencies as well. Two factors are responsible for the importance of financial planning – inflation and changing lifestyles. Financial planning can ensure that one is equipped to deal with the impact of inflation, especially in phases like retirement when expenses continue but income streams dry up. The second factor is changing lifestyles. Financial planning has a role to play in helping individuals both upgrade and maintain their lifestyle. Finally, sound financial planning can enable the investor to easily mitigate contingencies, without straining his finances. At its core, financial planning is not a very difficult task. All it takes is discipline and religious adherence to the principles of financial planning. Discipline has a part to play at every stage, from setting objectives to actually executing the plans that are meant to achieve those objectives Setting objectives, investing in line with one’s risk appetite, and asset allocation are some of the fundamental principles of financial planning One more important aspect not to be ignored is considering tax and inflation rates into all your investment decisions so as to compute the actual return that you get – this can be significantly different from the stated rate. The simple formula for calculating the Real Rate of Return (RRR) more precisely is:

What this means is that you won’t be right to go merely by the coupon rate on your investment. Look instead at the real rate of return.

How to Get Started?

Alice: Which road is the right one to take?
Mad Hatter: Depends on where you want to go?
Alice: I do not know!
Mad Hatter: Then any road will get you there!

“If you don’t know where you are going, any road can take you there”

~Lewis Carol, Alice in Wonderland

 

Unless you know where you are headed, you won’t get there. The objectives could range from buying a car, setting aside money for children’s education and marriage to providing for your retirement. The trouble is that most individuals tend to ignore the “What” part i.e. what do you want to achieve? Instead, they concentrate on the “How” part i.e. how will you achieve the same? This in turn, leads to an ad hoc and directionless investment pattern that may not yield the desired results.

There are some pointers that must be borne in mind, when you are setting objectives: Firstly, at any point in time, you are likely to face multiple objectives. For example, assume that you are a 35-year old individual with a 5-year old child and are yet to own a house property or provide for your retirement. Then, providing for the child’s education, accumulating a corpus for buying a house property and retirement planning are some of the pertinent objectives. What you need to do now is prioritize. Secondly, you are likely to find yourself in a situation wherein, despite the presence of clearly-laid out objectives, you lack the means to provide for all of them. The key lies in starting off as early as possible with the investible funds that you have and make up for the shortfall at a later date when hopefully you will have more funds at your disposal.Finally, setting objectives should not be influenced by external factors like your friends, relatives or peers. This is vital since what you set out to achieve is what you will eventually land up with.

How to Get There?

Having discussed how to set objectives, let’s now take a look at how you should go about achieving an objective of becoming a crorepati in next 30 years. We shall assume three scenarios, wherein investments made to achieve the stated objective (becoming a crorepati), yield returns of 12% pa, 15% pa and 17% pa.

Clearly, becoming a crorepati isn’t as difficult as it is made out to be!! In conclusion, getting your objectives right and having the necessary investment plans in place will ensure that you are on a sound footing to achieve your goals – and that’s a fact, not just a cliché. To cater for the investment styles of different persons (since we all are so different from each other), a suggested custom plan for allocation amongst various investment avenues are as given in a parallel link (Broad Custom Plans as per Life stage). Another link, Investing and Giving, gives out the plus and minus points of each investment avenue, as also the noble cause of Charity, which is actually an investment in your country’s future.

Finally, It’s All About Your Risk Appetite

Put bluntly, risk is the amount of money that the investor can afford to lose in the interim in his quest for a certain return on his investment. If an investor can afford to lose only a moderate amount of money, then his risk appetite is on the lower side. Below are highlighted some of the key points to keep in mind while evaluating your own risk appetite:-

• The choice of investments must flow from risk. However, remember that risk and returns are directly proportional to each other. Higher the risk, higher is the possibility of higher returns. The idea is to make your risk appetite, and not the investment opportunity, as the reference point.
• The risk associated with an investment has a lot to do with the investment timing. One reason why a lot of investors burn their fingers with the hot investment opportunities is mainly because, by the time they invest in an opportunity, it has already run its course and peaked.
• Another strange aspect of risk is that it decreases with time. As a prominent fund manager observed, equities are the riskiest assets over the short-term and the safest assets over the long-term. Thus, for long-term goals, go in for equities while debt products are the best for short-term goals.
• Investor appetite for risk does decline with an increase in age. Since equities can be volatile over the short-term, it is advisable to shift a majority of assets from equity to debt, as the investor approaches retirement age.

Basic Mantras of Saving Money

• Save at least 30-35 per cent of your monthly income in good quality savings instruments.
• Keep at least 3 months of your monthly income for emergencies. Alternately, get a good credit card with a self-imposed financial discipline to square off total outstanding in the very next bill.
• Clear all your high interest debts first out of the savings that you make

And, the Basic Mantras of Making Money

“Compound interest is the eighth wonder of the world

He who understands it, earns it …. he who doesn’t, pays it.”

~Albert Einstein

 

Start soonest – the sooner, the better. Trust in the power of compounding. Compounding is growth via reinvestment of returns earned on your savings. The earlier you start investing and continue to do so consistently, the more money you will make. The longer you leave your money invested and the higher the interest rates, the faster your money will grow. Research and history indicates these three golden rules for all investors:-

• Invest early.
• Invest regularly.
• Invest for long term and not short term.

Research and history also indicates these four common investment mistakes:-

• Investing without a plan.
• Not diversifying well enough.
• Ignoring risk.
• Getting married to your investments.

IN A NUTSHELL

• Inflation, i.e. a rise in the general price level, is one of the major factors that necessitate financial planning.
• Financial planning aids individuals upgrade and maintain their lifestyles as also helps meet contingencies.
• Setting objectives is the first step in the financial planning process. Each objective must be backed by a dedicated investment plan.
• When faced with multiple objectives, prioritize and start off with the most pressing one.
• Start early and make up for any deficit at a later stage. Don’t delay the investment process on account of small shortage of funds.
• Always evaluate the risk in an investment opportunity before the return. Invest in line with your risk appetite, not the expected return.
• Market linked investments like equities get less risky with the passage of time. In fact, Mutual Funds investing in Equity (shares) are the least risky if investment horizon is beyond 5 years!!
• Risk is a very personal thing; there is no formula to calculate it.
• Often at an advanced age, risk appetite declines.