What is Financial Plan Based Investing?
We keep hearing about the importance of financial plan based investing for our retirement, for the uncertainties in our future and to beat inflation. But life is more complicated than that – there are goals, aspirations, emergencies, constraints and more. Both the science and art of considering all these human aspects of investment, the big picture and planning for long term & short term investment, is called Financial Planning. Investopedia describes financial planning definition as
“A financial plan is a document containing a person’s current money situation and long-term monetary goals, as well as strategies to achieve those goals.”
It is not just individuals that need a financial plan, businesses have one too! Financial planning concept is all about creating a consolidated plan taking into consideration the nuances of a person’s life and the requirements that we can anticipate to arise. When the goals in the financial plan are met with appropriate investments, the result is happiness!
Objectives of Financial Planning
Successful financial planning is one that caters to the current net worth of an individual, his/her cash flows and maps a path to the destination where the individual wants to get.
The Process of Financial Planning
Calculating the individual’s net worth is the first step. This is done by mapping out all the assets and liabilities a person has accumulated over time.
Assets: House, cars, stocks, mutual funds, EPF, PPF, NPS, NSC, cash and the list goes on.
Liabilities: Credit card debt, mortgages, student loan, car loan and so on.
The next step is to determine the cash flows of the person – this helps in understanding the monthly needs for bills, services and products the person buys. Generally this should be done over a financial year to accommodate seasonal spending.
The last step, in a high level process, is to understand the person’s risk appetite based on age, family condition and all that is calculated above, before making a plan.
Business Financial Planning
When it comes to businesses, the financial plan revolves around capital budgeting. Which leads us, naturally, to the questions: What is capital budgeting? or What is capital budgeting decision?
Businesses have to access each project before it is undertaken to understand if this project will be profitable or not. Capital budgeting techniques are used to project cash inflows and outflows. These discounted cash flows allow businesses a peak into the internal rate of return(IRR) of a project which is then compared with the company benchmark to decide if this project should be accepted or not.
Personal financial management
Generally the personal finance management has 5 pillars, although this can change based on individual preferences. This is how one can be successful in financial planning:
To be able to live post retirement with low or no income while maintaining an expected lifestyle
- Goals/Life Events
To account for children’s education, marriage and other life events like an aspired world tour.
Health and life insurance are just necessary today to protect yourself from the financial pitfalls of unforeseen events. Car & home are also mandatory now with tighter norms.
- Tax Saving
Earning a lot is not enough if you are paying a high amount of taxes.
- Emergency Funds
Emergency funds are needed for situations like a recession, job layoffs and others, to be able to continue the important things in life.
Other things might be a bit obvious, but why are goals important in personal financial planning? A successful financial plan should take into account the large goals in an individual’s life and be able to fund it at a lower cost of capital. For example, a car that costs ₹15lakhs on road if taken on 100% loan from a bank at a rate of interest of 9% p.a. for 5 years, will cost ₹18,68,252 at the end of 5 years. The ₹3,68,252 can be reduced if not nullified by a good financial plan.
This is what a financial advisor does as a profession. He/she understands this holistic information about the customer and makes a financial plan. The short term plans which are towards goals like buying the above mentioned car would need a profit maximization strategy whereas a long term plan for retirement would need a wealth maximization strategy in place.
How to make a Financial Plan based Investing plan
Here is the process for arriving at an investment plan based on the financial plan drawn earlier.
- Assess current financial situation
- Set goals
- Calculate risk profile and time horizon
- Choose an investment strategy
- Monitor and rebalance investments
How frequently should you rebalance your asset allocation? Generally, this is done based on a time period like yearly, half yearly or quarterly. Alternatively, you can also do this based on portfolio performance and fundamental analysis – when asset allocation deviates by more than 10% (this value can be based on investor risk profile)
Importance of Financial Planning
Over an average lifespan of 72 years in India, the first 20-25 years are productive for learning but unproductive in terms of earning money. The span of 35 years over 25-60 years is basically the productive time for most individuals where one has to manage family, goals, health, pleasure, taxes and savings for retirement. The 12 years, 60-72, on average post retirement also need enough savings despite inflation to live life with a certain lifestyle.
Inflation erodes into accumulated funds. Inflation can vary and be quite high, especially in a few sectors like healthcare & education. That is why financial planning is important.
Benefits of Financial Planning
- Save and invest more for your goals to achieve more
- Helps reduce debt and cost of debt through a planned approach
- Better risk diversification based on investment plan and risk profile
- Save taxes
- Sustain an improved lifestyle till the end of life, ie conditions for lasting Happiness
A solid financial plan based investing puts one’s life firmly on track. Coupling it with an Investment Plan ensure that the goals are met within the desired time frames. While money cannot buy happiness, it is also true that having a basic modicum of wealth enables the conditions required for living a happy life.