Chapter 4: Financial Planning
Financial planning is:
- a process of identifying one’s life’s goals, translating these identified goals into financial goals and managing one’s finances in ways that will help one to achieve those goals.
- It involves assessing one’s net worth, estimating future financial needs, and working towards meeting those needs through proper management of finances.
- Financial planning takes into account one’s current and future needs, one’s individual risk profile and one’s income to chart out a road map to meet these anticipated needs.
- Individual’s goals may be: Short term: (Buying an LCD TV) or medium term (Buying a house) pr long term (Education or marriage of one’s child or post retirement provision).
Savings may be considered as a composite of two decisions.
- Postponement of consumption: an allocation of resources between present and future consumption.
- Parting with liquidity (or ready purchasing power) in exchange for less liquid assets.
- If we look at the above life cycle, we would see that three types of needs can arise. These give rise to three types of financial products.
- Enabling Future Transactions: For meeting a range of anticipated expenditures.
- Specific Transaction Needs: These needs are related to specific life events, which require a commitment of resources. Example: Making provision for higher education / marriage of dependents. General transaction needs: Amounts set aside from current consumption without being earmarked for any specific purposes – these are popularly termed as ‘future provisions’
- Meeting Contingencies: Contingencies are unforeseen life events that may call for a large commitment of funds. These are not met from the current income and hence need to be pre-funded. Examples: Death, disability or unemployment leading to loss of income
- Wealth Accumulation: These needs arise from the desire to accumulate wealth by way of prudent investments in favorably market conditions.
Three types of products in the financial market:
The longer the time period of our investments, the more they will multiply.
When is the best time to start financial planning?
Elements of financial planning include:
Investing – allocating assets based on one’s risk taking appetite,
Tax and estate planning, and
Financing one’s needs
- Financial planning should ideally start the moment you earn your first salary.
- Purpose of Cash Planning: 1. Manage income and expending flow, establish a reserve of liquid assets, meet emergency needs. 2. Create and maintain systematically a surplus of cash for capital investment.
Steps for cash planning:
Step 1: Set your goals and Prepare a budget.
Step 2: Analyse the expenses and income flows over the last six months; Categories expenses into fixed and variable expenses ; Try to reduce variable expenses, as you may not have control on fixed expenses.
Step 3: Predict future monthly income and expenses over the whole year; Design a plan for managing cash flows
- Insurance Planning: This involves constructing a plan of action to provide adequate insurance against such risks. The task here is to estimate how much insurance is needed and determining what type of policy is best suited.
- Risk Tolerance: It is a measure of how much risk someone is willing to take in purchasing an investment. Risk tolerance varies with age and time.
- Time Horizon: It is the amount of time available to attain a financial objective.
- Longer the time horizon, the less concern is there about short-term liability.
- Liquidity: Ability to convert the investment into liquid cash.
- Marketability: It is the ease with which an asset can be bought or sold.
- Diversification: It is the ease with which an asset can be bought or sold.
- Tax Considerations: Many investments confer certain income tax benefits. One may like to consider the post-tax returns of various investments.
Selection of appropriate investment vehicles based on the above parameters:
- Fixed deposits of banks / corporate,
- Small savings schemes of post office,
- Public issues of shares,
- Debentures or other securities,
- Mutual funds
- Unit linked policies that are issued by life insurance companies etc.
Retirement Planning: Retirement planning involves three phases
- Accumulation: Accumulation of funds is done through various kinds of strategies to set aside money for investment with this purpose.
- Conservation: Conservation refers to the efforts made to ensure that one’s investments are put to hard work and that the principal gets maximised during the individual’s working years.
- Distribution: Distribution refers to the optimal method of converting principal (which we may also call the corpus or a nest egg) into withdrawals / annuity payments for meeting income needs after retirement.
- Tax planning is done to determine how to gain maximum tax benefit from existing tax laws.
- Inflation is a rise in the general level of prices of goods and services in an economy over a period of time.
- Shares can be categorised under wealth accumulation products.
- Life insurance can be categorized under contingency product.
- Bank deposits can be categorised under transnational products.
- Individual with an aggressive risk profile is likely to follow wealth accumulation investment style.