What is financial planning?
In simple terms, financial planning is aligning your finances (income, expenses & investments) to your short term & long term financial goals.
(Here is what Wikipedia says about Financial Planning)
Though it may seem quite simple, it is not that straightforward. Nor is it an uni dimensional thing like – just chase high returns.
While preparing a financial plan for ourselves and our family, we tend to focus on investment part of it. Agreed, it is an important aspect of financial planning, but it is not the only thing.
We often tend to get attracted by the investments that give higher returns. In most of the cases, equities (including equity mutual funds) have been that asset class which gave maximum returns. However, in the pursuit of high returns, do we lose the sight of other aspects of financial planning journey?
Here are 5 things that should form an important component of your financial planning.
1 . Understanding your financial goals
Any journey usually begins with a destination in mind. Any financial planning process begins with understanding your financial goals. This aspect is more personal than financial. Your financial goals are a step towards achieving your personal goals.
And surprisingly, a huge chunk of population approach financial planning in an aimless manner, without any goal in mind.
Understanding financial goals broadly include the following:
- Understanding major expenses in future (one-time or recurring or unforeseen) and the likely timelines.
- Identifying how much money will be needed for those expenses (considering inflation, including lifestyle inflation, and cost of living at that time)
- Identifying how will you move towards those goals. (E.g. how much money you need to save? What investments can help you achieve that? What kind of lifestyle suits your need if you want to achieve those goals etc.?)
2. Budgeting and expense management
Saving money is an important fist step towards moving towards your financial goals.
Understanding where your money comes from and how much and where it goes is an important first step towards understanding how much money you can save.
If you have any debt, how do you plan to pay it off?
With proper budgeting and hence understanding what your savings (and hence rate of investment) are important inputs towards understanding not just your financial goals but also your current lifestyle & affordability.
While you are planning for the future, it is good if you pay attention to the present as well!
3. Safety of capital
This can be a tricky goal. Prediction of future is always tricky. Isn’t it?
Before understanding this aspect, it is important to understand that there is a correlation between risk and expected returns. In other words, if something can potentially offer higher returns, there is likely to be higher risk. So, if most of the assets are in somewhat riskier assets (like equity) you may end up getting very good returns, but there is a small probability of not being able to recover your entire initial capital. In fixed deposits, you are almost sure of getting back the predicted amount, but this may be potentially lesser than what equities may promise.
So what do you chase? – High returns or safety of capital? Capital protection or capital growth?
Historically, in long run, among other asset classes, equities (including equity mutual funds) have given good returns. And even though likelihood of this happening in future too is good, it can’t be guaranteed.
Hence, at some stage of your life capital protection becomes equally important.
One of the ways to approach it is investing for long term goals can be mostly focused on equities and that on immediate/ short term goals should be focused on capital protection (mostly debt instruments like liquid funds or bank fixed deposits). At some point of time, your long term goals start becoming short term and then immediate goals. Hence, your asset allocation should keep pace with this shift. It should also keep pace with what your comfort level with your asset allocation (and ensuing risk) is.
Whatever approach you choose, it should be with awareness of potential risk and returns and should give you a good degree of peace of mind!
4. Have an emergency fund
Emergencies can strike any time. And lot of expenses can set your financial plans back. However, one way to plan for it and mitigate its impact is to have an emergency fund in place. This can be for emergencies like loss of job, medical emergency, or anything that need your immediate financial attention.
As discussed in an earlier post, I would recommend having an emergency fund for at least 6 months and have another 6 months of funds accessible to you. (That makes it a year’s emergency fund, at least).
You emergency fund is unlikely to grow as fast as your other investments. But when there is need, it can be priceless. And hence, it is a must in our financial plans.
5. Get adequately insured
Insurance is a risk management tool. Insurance is NOT an investment, as many people think. Buying term plan and an investment plan (say mutual fund) is better for both insurance and growth as compared to buying some mishmash product (promising insurance and good returns both).
That being said, what all insurance should you have?
There is no dearth of what all you can insure. As a rule of thumb, what are the things critical to you and family, which can have adverse financial impact if you lose?
Some options are – life, health, house, car, travel plans etc. – and all have insurance products associated with it.
Among them, arguably life and health are the issues which can probably have maximum financial implication on your family, if something goes wrong. Hence these are the insurance that should get priority. Start with a term life insurance and a health insurance.
Some may be mandatory to get – say, car or 2-wheeler insurance, so you need to have that. If you think you need any other insurance cover, evaluate the need and take it if needed.
Insurance products may come in different shapes and sizes with different inclusions and exclusions. For instance, there are lot of possibilities in health insurance segment itself (e.g. critical care, cancer cover etc.).
Decide what financial risks you are OK with you want protection against. After all, for all insurance you take, you need to bear some expenses every year in form of premiums.
But start with term life& health insurance. And remember, insurance is NOT an investment. DO NOT buy it for returns. Insurance is a risk management tool. Buy it for risk management and risk mitigation.
To sum up:
Financial planning involves not just for your future goals and expenses but should also focus on the present. Hence, a holistic perspective is important while making a financial plan. Hence apart form your financial goals, aspects like budgeting and risk management also become important in addition to investing towards your financial goals.