With recession knocking on our doors, bearish market and trouble just round the corner, you must be wondering who needs financial planning. Well here is where people falter. There are loads of versions of what financial planning is. Some say it is the science of where to invest. Others say it is the luxury of only the rich and the famous. Financial planning is not just about investment planning nor is it a tool at the disposal of the rich. In fact, financial planning does not even start with investment planning. Investment planning is the second tier in financial planning. People with limited finances stand to benefit the most through financial planning as it helps them to optimally utilize their limited resources.
So what is Financial Planning?
To an ignorant person financial planning would mean to earn enough to be able to enjoy all the luxuries of life. Wish life was that simple! But little do we realize the importance of responsibilities, needs and dreams to be fulfilled once we begin earning. One term, which summarizes these three things, is ‘goals’. We all have to strive hard to achieve our goals. But can just hard work alone and no proper planning help one achieve these goals? Difficult! Almost impossible! Here is where financial planning comes into picture.
A financial plan is a comprehensive strategy tailor-made in accordance with your financial goals taking into account your current financial position and designing a plan that helps you achieve your future financial destination in the most effective manner.
Why and how?
Let us start with ‘why financial planning’. Many a times it happens that we have an emergency situation but do not have the funds to help us tide over the crisis. We have a medical insurance coverage but when a major illness strikes, we realize that the insurance amount is barely enough to cover the basic hospital expenses. We have invested our hard-earned money in AAA+ rated high-return market instruments but when we need the cash we realize that these investment avenues have a lock-in period, which cannot be withdrawn. We could have also invested in some great blue-chip stocks but when we need the money we realize that the markets have fallen and our have more than halved. Each one of us can surely.
Relate to at least one of these situations. In such a situation, we feel we should have planned for something like this in advance. To make sure that in the face of an unfortunate event we are well-prepared to meet all the eventualities, a well-constructed financial plan is a must. A financial plan helps you to take control of your financial future keeping into account your financial present.
There is a general feeling among most people that a financial plan is only useful if you have millions in your kitty. While it is true that millionaires too need financial planning, it is almost mandatory for people with limited resources to have a sound financial plan. This is because when emergency strikes, the millionaires will have tons of additional funds to face the crisis but people with limited resources have to make sure that every single penny is available at their disposal. Also, bear in mind that financial planning is equally important for income earners of all age groups.
Financial planning at different stages of life:
25–35 years: In this age-bracket, there are income earners who have just started their career and young couples with or without kids. Income earners in this group will reap maximum benefit if they plan their finances as they have the first mover’s advantage. In other words, the sooner they start, the greater are their chances of building a sound financial future for themselves and their families. At this juncture they might not have enough income but financial planning will help them draw a road map on which they have to walk and it will give them focus as to how much to save and spend and what their finances would be after “x” number of years. Also, we cannot forget the motivation this will give them to earn more to fulfill their dreams.
36-55 years: Income earners in this group may be a little late to start their journey of financial planning but are better placed financially. They would have more or less settled in their jobs and would be earning regular fixed incomes with fixed appreciations every year. Financial planning will help them realize the importance of risk management that is contingency planning, insurance planning as most of them will have grown up children and families to think about. Also, financial planning will help them save for the impending retirement age.
55 years and above: People nearing retirement age and those who have not planned for retirement earlier – retirement planning can help them prepare them- selves for a better retired life. In fact, at this stage people have to be more prepared than the above- mentioned income groups as they will no longer be earning hefty pay packets. For most of them their only source of income would be either pension or interest income. Well-planned retirees will not have any problem and can lead happy, independent and fulfilled lives.
Now that you are convinced how important financial planning is, let’s begin with ways to go about charting a financial plan.
The most important aspect of financial planning is what you want to achieve in life and when you want to achieve them. There are several goals which everyone would like to achieve in their life. Here is a small guide which will help you in your goal-setting.
Goals are the milestones in life, which you would like to achieve. As we already know these milestones can be broken into needs, responsibilities and dreams. This way you can prioritize the most important goal you want to achieve first and then move on to others.
The examples of responsibilities are providing for your parents, your children, their education, marriage, health, etc. Buying a house, providing for your retirement, saving for any unseen events, providing for day-to-day life and other things fall under the category of needs and dreams or your aspirations can be as simple as riding an elephant to going on a world tour, buying solitaire diamonds, etc. Your dreams may seem far-fetched but there is no harm in listing them as it is a constant reminder to work harder.
Once the daunting task of listing your goals is done then comes the second part which is “when” or “in what time frame” you want to achieve these goals.
Time frame: This factor is equally important because we work around a specific timeline and this helps us in focusing on our goals. The time frame is especially important when it comes to investments since the number of years it takes to achieve our goals would decide the investment avenues.
Sometimes you are not sure as to when you would like to achieve a goal like say buying a car. But a round-about time frame is useful as it will help you make the right investment decision.
Value: There is one more task left after listing the goals and time frame; the task of putting financial figures against your goals, which in simple terms means how much are you willing to spend for a particular goal. As without knowing the value, how can one plan for it? For example you need to spend for your child’s education after 5 years. You need to put an approximate figure as to how much would it cost in today’s terms. Say in today’s term you will have to spend Rs 50,000.
After listing today’s cost, inflation cost needs to be taken into account because what you could buy for Rs 1,000 today, you will have to shell out around Rs 1,400 after 5 years (taking into consideration an average 7% inflation cost). So similarly in the above example, if in today’s cost, you have to spend Rs 50,000, taking inflation into consideration, you need to plan for Rs 70,127 after 5 years.
How was this figure reached?
Future Value (FV) = Present Value (PV)* (1+ Rate of Inflation) ^ No of years to Goal
FV = 50,000 * (1+ 7%) ^ 5
FV = Rs 70,127
The above chart lays a foundation on which you need to prepare your plan. As this gives you a focus as to what you need to achieve in life and how you need to earn, save and spend.
The best way to make the above task simple is through a chart as shown below:
(The above table is just an example. It will vary from individual to individual)
There are many intricacies involved in financial planning. It is a four-tier plan, starting with risk management wherein your contingency or emergency fund and insurance planning is done. The second tier is your investment planning. The third tier is retirement planning, tax planning and last but not the least is estate planning. Financial planning is not simple. This is just the first step towards a secured future.
Source: Nirmal Bang's Beyond Market
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