Introduction to financial Planning

Introduction

Few people in India today really understand the importance of financial planning. While for many, financial planning begins and ends with collecting ULIPs (unit-linked insurance plans) and endowment plans without any rhyme or reason, there are others who simply associate financial planning with tax savings. Financial planning is not just about having good stock-picking skills, or identifying the right mutual fund schemes, or arming you with dozens of ULIPs. It is a holistic approach to managing your overall asset portfolio by taking care of every aspect of your life, including risk management, goal-setting and achievement, asset allocation, and retirement planning. The following are some of the aspects of financial planning:

 

Effective risk management:

A sound financial plan begins by identifying and covering all the potential risks that you are exposed to. These include life insurance, medical insurance, mortgage insurance, home and household insurance, automobile insurance, among others. Once these risks are appropriately covered, you will be emboldened to take on bigger risks in life. Clearly, this is one of the most important aspects in the financial planning process, and every sound financial planner should begin by ensuring appropriate coverage for you. Any failure to take necessary steps in this regard will raise your future risk-taking ability.

 

·         If you are a 25-year-old bachelor with dependent parents, then your life insurance needs will differ from that of a 40-year-old with dependent parents, wife and kids.

·         Similarly, if you fail to cover your dependent parents for medical insurance, then one major surgery is probably enough to blow a big hole in your pocket—something that you can ill-afford if you are serious about accumulating long-term wealth.

·         If you have a 20-year home loan, then taking out a mortgage redemption plan will ensure that the responsibility of paying the EMI does not fall on your dependents in the event of your untimely death. In a nutshell, coverage of one’s risks helps to preserve wealth and is one of the most crucial aspects of financial planning. Not having a financial plan in place could lead to unnecessary stress and hardship when one of life’s nasty surprises come visiting you. The result—you (or your dependents) may end up running from pillar-to-post borrowing money, and in the process, having your financial goals derailed.

 

Goal-setting and achievement:

The importance of financial planning is often underestimated. Planning ahead is about creating realistic financial goals that will facilitate financial independence in your life. A good financial planner should help you to articulate your short-term and long-term financial goals in life. So how does one go about achieving one’s financial goals? Well, to begin with, financial planners analyze your profile thoroughly based on your age, current income, monthly savings, current net-worth, number of dependents, and your short-term and long-term financial goals. Planners then do a post-mortem of your existing monthly savings and investments and tweak it accordingly so that you are on the right path to achieve your financial goals in a timely and convenient manner. Short-term goals like buying a car or taking an international vacation can be planned ahead through investments ranging from conservative fixed deposits that ensure wealth preservation to systematic investment plans in an equity or balanced mutual fund. The shorter the time horizon, the more conservative should be the portfolio mix to ensure capital preservation.

 

Long-term goals like your child’s higher education abroad should be planned ahead carefully for two reasons. One, because the amount involved is huge—an MBA education abroad costs nearly Rs20 lakhs today, but 20 years later, when your child is ready to enrol for an MBA, assuming inflation at 5% per annum, the value of the course will skyrocket to more than Rs50 lakhs. Long-term financial planning helps you to beat inflation and meet your financial goals comfortably. Planning ahead ensures that you pay all your bills on time and maintain your credit rating in good standing

Clearly, goal-based financial planning is the need of the hour in India. Unlike the developed countries, the concept of financial planning and wealth management is still at a nascent stage in the country. Given the lack of a well-defined and committed financial planning, the process of wealth management has been, at best, an ad hoc, haphazard process. Today, you can effectively use asset allocation to build long-term wealth and achieve your financial goals.

 

Appropriate asset allocation:

A sound financial plan should take Into consideration investment across asset classes, including stocks, Bonds, fixed deposits, gold, real estate, among others. As each asset class behaves and moves differently, the right asset allocation mix will help you to benefit from effective portfolio diversification. In fact, even among stocks, there should be meaningful allocation across sub-asset classes, such as large-cap, mid-cap or small-cap stocks or mutual funds, and the risks that each of these entail should be properly understood. Asset allocation is typically pre-defined and Differs for every individual depending on his overall risk profile, age, current income and networth, time horizon, financial goals, number of dependents, among others.

 

• A 30-year-old can have a greater proportion of stocks and equity funds in his portfolio compared to a portfolio of a 50-year-old. A high concentration of equity helps in long-term wealth maximization, especially if age is on your side.
• If you have a low tolerance for risk, then a high equity-based portfolio may not be the right thing even for a 35-year-old. On the other hand, if you are a 55-year-old with a high risk tolerance, you can still take aggressive bets on equity, although you need to ensure that You don’t violate your predefined asset allocation limits.
• Time horizon also plays an important role in the asset allocation process. The greater your time horizon, the more risks you can afford to take, and higher will be the potential return over the long term.

 

Asset allocation should not only be pre-defined, but it also must change from time to time. For instance, you can define an asset allocation for yourself that changes every five years (see Table 1). As and when you cross a particular threshold age, you should change your asset allocation mix accordingly.

 

No pre-defined asset allocation is complete without portfolio rebalancing.

This is a periodic procedure that allows you to rebalance your portfolio to the original pre-determined asset allocation mix. For instance, you are 50 years old with a pre-defi ned asset allocation of 50 : 30 : 20 into equity, debt and gold, respectively. Say, one year later, the stock market rises by 50%, whereas the returns on debt and gold remain stable. Accordingly, your asset allocation changes to 60 : 24 : 16. In such a scenario, you need to sell some of your stocks and buy more debt and gold to bring your investments back to the original mix. In other words, by selling (buying) stocks at higher (lower) levels, portfolio rebalancing helps you to buy low and sell high.

 

Retirement planning: Today, with life expectations going up, people must factor for nearly one-third of their lives to be spent post-retirement. That means you need to build a substantial nest egg to ensure that you can continue living with the same standards that you did just prior to retirement. In other words, by investing for the long term, you can let your money work for you to help you achieve your retirement goals. Today, a financial planner should be able to

guide you through the range of retirement products available in the market, including ULIPs, endowment plans, unit-linked pension plans, including the New Pension System (NPS) recently announced by the Government of India.

 

Importance of financial planning

• Financial planning is important for the following reasons: Through risk management, it ensures appropriate coverage that could vary depending on whether you are single and working (with or without dependents), newly married (with single or both spouses working), married with kids (dependent or financially independent children), or in the post-retirement phase. Risk coverage ensures that your financial goals are not derailed and your wealth is preserved over the long-term.
• Through goal-setting and the right asset allocation mix, you can ensure that your short-term and long-term financial goals are met.
• There are many who believe that financial planning is only for the wealthy and that those with limited income cannot indulge in financial planning because they don’t have anything to plan with. However, the real truth is that those with limited income need financial planning more than those with high disposable incomes.
• You may be earning a high income, but you may end up spending it all and some more. Similarly, you may earn limited income, but while you may be a careful spender, much of your earnings may be consumed towards debt servicing and living expenses. Financial planning ensures that you make the most out of your limited (or abundant) resources.

 

Conclusion

In a nutshell, financial planning helps you to deal with the impact of inflation, thus facilitating long-term goal achievement and retirement planning. Financial planning also allows you to maintain and upgrade your lifestyle, whether it is wealth preservation through appropriate risk coverage or wealth accumulation through the right asset allocation mix or comprehensive wealth management through a holistic approach towards determining the right risk-reward ratio on your overall portfolio.

 

Source: thefinapolis