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Financial planning is the process of developing a personal roadmap for your financial
well being. The inputs to the financial planning process are:
- your finances, i.e., your income, assets, and liabilities,
- your goals, i.e., your current and future financial
needs and
- your appetite for risk.
The output of the financial planning process is a personal financial plan
that tells you how to use your money to achieve your goals, keeping in mind inflation,
real returns, and taxes. In short, financial planning is the process of systematically
planning your finances towards achieving your short-term and long-term life goals.
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Life Goals
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Most people nurture dreams of owning a bigger house or car, exploring the world,
giving their children the best possible education, a blissful retirement, etc. Basically,
these dreams are life goals. Consider this example: |
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Mr and Mrs Khanna, 35 and 32 respectively, have a three year old son. Both work
in private sector companies. Mr Khanna plans to retire when he’s 50. From their
current one bedroom rented suburban Mumbai apartment, the Khannas hope to move to
their own two bedroom apartment costing around Rs 25 lakh within the next five years.
They own a small car, for which they have availed of a loan. Mr Khanna reckons that
he will need Rs 15 lakh for his son’s higher education 15 years later. He also wants
to build a corpus of Rs 75 lakh for his retirement. |
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While distinguishing short term goals from long term goals, you must keep in mind
that, as a general rule, any life goal that needs to be met within five years can
be considered as short term. Beyond that, any other goal can be classified as long
term. By this classification, the Khannas’ goals can be classified as follows: |
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Using a similar yardstick, you may classify your own life goals. Each of them needs
financing. How you plan your finances, to have the right amount at your disposal
at the right time, is what financial planning is about. |
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Importance of financial planning
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Can you manage without financial planning? Many people do, but they may find—often
when it’s too late—that they don’t have the means to achieve their life goals. |
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For example, people today realize the importance of living life to the fullest.
Consequently, many opt for early retirement from full time jobs, as compared to
a few decades ago, when most people worked until the maximum retirement age of 58-60
years.
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The average person can, today, expect to live a healthy life well into his or her
seventies or eighties, which means that retirement life is almost as long as working
life. Financially, it implies that savings (after taking into account inflation)
should be enough, not just to maintain the same lifestyle for almost 25-30 years,
with no new income, but also to take care of medical expenses, which are usually
high the older a person gets. Planning for all this is a tall order for anyone.
That’s why it’s critical for everyone to plan their finances from an early age.
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So, what do you need to know about yourself when thinking about a Financial Plan?
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Your financial plan entirely depends upon how much effort you are willing to put
in. This means not just having a good handle on the details of your income and expenses,
assets and liabilities, but more importantly on the following items:
- Time Horizon and Goals
- Risk Tolerance
- Liquidity Needs
- Inflation
- Need for Growth or Income
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No doubt there are other factors that are important as well, but we believe that
the above five require a more detailed study on your part.
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Time Horizon and Goals: It is important to understand what your goals are,
and over what time period you want to achieve your goals. Some goals are short term
goals those that you want to achieve within the year. For such goals its important
to be conservative in one’s approach and not take on too much risk. For long term
goals, however, one can afford to take on more risk and use time to one’s advantage.
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Risk Tolerance: Every individual should know what their capacity to take
risk is. Some investments can be more risky than others. These will not be suitable
for someone of a low risk profile, or for goals that require you to be conservative.
Crucially, one’s risk profile will change across life’s stages. As a young person
with no dependants or financial liabilities, one might be able to take on lots of
risk. However, if this young person gets married and has a child, he/she will have
dependants and higher fiscal responsibilities. His/her approach to risk and finances
cannot be the same as it was when he/she was single.
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Liquidity Needs: When do you need the money to meet your goal and how quickly
can you access this money. If you invest in an asset to and expect to sell the asset
to supply you funds to meet a goal, then please understand how easily you can sell
the asset. Usually, money market and stock market related assets are easy to liquidate.
On the other hand, something like real estate might take you a long time to sell.
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Inflation: Inflation is a fact of our economic life in India. The bottle
of cold drink that you buy today is almost double the price of what you paid for
ten years ago. At inflation or slightly above 4% per annum, a packet of biscuits
that costs you Rs 20 today will cost you Rs. 30 in ten years time. Just imagine
what the cost of buying a car or buying a home might be in ten years time! The purchasing
power of your money is going down every year. Therefore, the cost of achieving your
goals need to be seen in what the inflated price will be in the future. |
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Need for Growth or Income: As you make investments, think about whether you
are looking for capital appreciation or income. Not all investments satisfy both
requirements. Many people are buying apartments, but are not renting them out even
after they take possession. So, this asset is generating no income for them and
they are probably expecting only capital appreciation from this. A young person
should usually consider investing for capital appreciation to take advantage of
their young age. An older person however might be more interested in generating
income for themselves.
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Benefits of financial planning
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Here’s a list of the benefits that a well chalked out financial plan can bring about:
- Helps monitor cash flows and
reduces unnecessary expenditure.
- Enables maintenance of an optimum
balance between income and expenses.
- Helps boost savings and create
wealth.
- Helps reduce tax liability.
- Maximizes returns from investments.
- Creates wealth and ensures better
wealth management to achieve life goals.
- Financially secures retirement
life.
- Reviews insurance needs and
therefore also ensures that dependents are financially secure in the unfortunate
event of death or disability.
- Lastly, it also ensures that
a will is made.
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Financial planning can help you achieve peace of mind since:
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