Financial Planning

Definition

A financial plan is a specific dynamic plan that revolves around managing income, expenses and investing savings in a manner that any individual meets his/her long-term goals. Planning the finances on an individual level and at a house-hold level is essential for everyone.

The rise in the annual cost of goods and services is called inflation. Inflation is a silent killer of wealth. Especially in high inflation countries like India, where inflation has averaged 6-8% over a while, inflation erodes the value of savings, and hence financial planning is a critical exercise. Inflation reduces purchasing power. Let's understand the impact of inflation with the below example:

• The table shows how much money would be needed in 10 and 20 years from now to purchase something that costs Rs 1 lakh right now. So, in 10 years, any article that costs Rs 1 lakh today would cost Rs 1.21 lakhs if the inflation rate is 2% per annum and Rs 1.79 lakhs if the inflation is 6%. A small change of 4% led to the costs rising by more than 50% over a 10-year horizon.

• High inflation is very destructive, especially over long periods. Over a 20-year horizon, an article that costs Rs 1 lakh would cost Rs 3.2 lakhs (3.2x of its current value) if the inflation rate is 6%.

Hence, prudent financial planning always revolves around investing surplus money such that the returns from investments are higher than the inflation rate. Otherwise, inflation erodes savings over time, and this is also called a loss in purchasing power.

Financial planning is a necessity to overcome situations where there is a sudden outflow or requirement of money at short notice. Generally, such crises are due to unforeseen events, such as the death of a family member or an accident resulting in healthcare costs. A good financial plan always counts on creating a provision for emergencies and helps a person deal with such contingencies. Not planning for them can cause a significant blow to an individual’s finances and the ability to achieve longer-term goals.

Every person aspires for a better standard of living, which necessitates higher expenses. People aim for different things – such as owning a house or a swanky car, taking overseas vacations, or spending on fashion and accessories. A good financial plan is aligned to such goals and works towards getting a person to achieve his/her goal and maintain the standard of living at the same time.

Risk Profiling

Investments are a vital component of any financial plan. Return requirements drive any investment plan. However, there is an essential factor to consider before making investments – The key being the risk profile of the individual.

Risk in financial or monetary terms means the uncertainty in achieving the desired returns. Risk and return are two sides of the same coin. Any individual who wants a higher return from investments also has to take higher risks to achieve these returns, which in turn means that the uncertainty of achieving the returns also becomes higher.

In terms of asset classes, generally, the equity asset class delivers the highest return but also has the highest risk. Comparatively, debt or fixed income generates lower but more certain returns. A risk profile of an investor determines how much risk the investor can take to achieve desired returns, and this drives the investment allocation into equity and debt.

Risk profiling has two aspects,and these aspects are unique for every individual:

This is the amount of investment risk or actual losses that an investor can absorb. Generally, a person with considerable savings/wealth has a higher risk capacity, as he/she can withstand more significant losses without impacting the ability to pay general expenses. Risk capacity is lower for people who have a lower asset base, as they can afford to lose less money. In general, the risk capacity increases with higher income and decreases with higher expenses. Also, risk capacity decreases with increasing age. People closer to retirement would have a lower ability to absorb losses. Individuals in the early stages of their career can manage losses better as they have several years to earn and make right the losses.

This is unique to every person and depends on psychological factors such as upbringing, culture, and the general outlook towards money. Some people have high-risk tolerance, which means the general ability to take risk is considerably higher. People who fall into this category would generally comprise of those who are keen to invest their monies into financial instruments that can generate extraordinary returns even at high risk. On the other end of the spectrum, some individuals have very little risk tolerance and prefer safety to returns. Such individuals would choose specific and generally lower returns in preference to higher risk asset classes. These individuals would prefer to invest their money into fixed income mutual funds that generate lower yet sustained returns over time.

Risk profiling is essential before making investments. A person who has both a high-risk capacity and tolerance would likely invest in higher returns but riskier investments – such as small-cap funds (funds that invest money into smaller companies). Conversely, a person who has a low-risk capacity and risk tolerance should ideally invest into the more conservative funds, such as liquid funds, which are safe although they generate low returns. In general, most people lie somewhere in between and hence would have different allocations to equity and debt. Any investment plan must start with risk profiling as the first activity.

A typical financial plan

A good financial plan is a comprehensive picture of your current finances, your financial goals, and the steps that you are taking to achieve these goals. Hence a typical financial plan should have the below components

A financial plan should have comprehensive information on income imminent from all sources. Typically, beyond salaries, other sources of income can be in the form of rental earnings from properties, dividends from shares or mutual funds, or coupons from bonds. A complete picture of income is essential to compute a cash flow picture.

A break-down of expenses into recurring and discretionary is vital to create a spending pattern that aligns with the spending behaviour of individuals.

A financial plan aligns to a financial goal. The goals should always be SMART – Specific, Measurable, Achievable, Relevant, and Time-Based. A smart goal would translate into a well-defined rate of return, which is required to achieve these goals. A combination of the necessary rate of return and the risk profile would also determine the ideal portfolio allocation for investments.

A well-defined investment plan would take into consideration all the above factors. An investment plan allows the proper deployment of money into specific investment vehicles such as funds, real estate,and others. An investment plan, including all its components, has to be periodically monitored and altered as the risk-return profile changes.

A financial plan must always be able to deal with unforeseen emergencies. Therefore, specific insurance plans such as those that help manage health, life are a necessary part of a financial plan. In addition to protection, a financial plan would help determine the quantity of security too. This helps retain desirable living conditions even through unexpected contingencies.

Do's and Don’ts of Financial Planning

We should keep a few things in mind from a financial planning perspective and try avoiding inevitable mistakes. The table below discusses some do’s and don’t’s of financial planning.