Many a times we shy away from making a full-fledged financial plan for ourselves thinking that the long term investments we are making are enough, or that it requires expertise, all the while not realizing how important it is for our financial well being. In this article we will discuss about the rewards of having a financial plan and how to get started in making a personal financial plan for yourself following a few simple steps. There is also a free downloadable excel file at the end which will help you to make a personal financial plan. By the end of this article you will not only have a financial plan for yourself but also know about the various components of a sound financial plan, the concept of time value of money and asset allocation for each goal based on risk and returns.
Rewards of having a financial plan
Having a sound financial plan for yourself and your family can reward you in more ways than you think. Here’s how:
Happiness owing to a sense of security – A sound financial plan covers aspects like planning for insurance, retirement and other important milestones in your life thus giving you a sense of a financially secure future and adds to your mental peace and happiness.
Higher accumulated wealth with same income – If you plan and invest your savings in proper channels rather than haphazardly parking them you can make much more money in the long term. For example, by simply cutting down on some frivolous expenditure and saving Rs 3,000 extra monthly you can save and accumulate around 44 lakhs more (with an investment of around 10 lakhs @ 8% compounded annually for 30 years).
Taking advantage of earning opportunities – Being financially aware can make you realize the true potential of your savings. An emerging country like India has a lot of investment opportunities and once you have a financial plan and know exactly how much surplus you have and the risk you can take on it, you can really multiply your fortunes. Carrying forward the same example above, if we make the same investment of Rs 3,000 extra monthly @ 10% instead of 8% we can accumulate around Rs 65 lakhs i.e. 47% more. Thus, by reading a bit more, being aware of the opportunities and making informed decisions, you can make much more with the same amount of income and expenses.
Better achievement of life goals – Making a plan gives you an opportunity to reflect on your current financial health and understand your future requirements which enables you to have clarity on your goals. Once your roadmap is prepared and you know how much you need when and for what you will be in a better position to understand which investment avenues are more suitable to you according to your goals and would help you to maximize your returns.
How to make a financial plan for yourself
Step 1 : Know your present financial position
Make an income and expense statement that enlists your monthly income and all your monthly expenses giving a clear idea of how much you make and how much you save. Additionally make a balance sheet for yourself where you list all the assets you own and the liabilities you owe. The excess of your assets over your liabilities is your net worth.
Step 2 : Enlist your financial goals
When enlisting your goals, make sure you have considered the following components in order of priority (the order is subjective from person to person). Just because a component has lower priority doesn’t mean that you invest in them only after taking complete care of your more prioritized components. It just means that you put money first into higher priority components and then allocate the remaining surplus funds proportionately in less prioritized components every month. This is necessary because it is always more rewarding to start investing at least some money in retirement in early years (say twenties) when retirement planning seems to have lower priority in our minds, as the effect of compounding on these first few installments can really create wealth for us in the long term.
Health Insurance / Mediclaim : Health is your biggest asset and a good health insurance or mediclaim policy that takes care of the probable medical expenses of your entire family is an absolute necessity. This is because medical expenses are the most unavoidable type of expenses and you will have to incur them irrespective of your affordability.
Emergency Fund / Liquidity : There may be periods of uncertainties or mishap in anyone’s life like unemployment, accidents etc. because of which you may be out of work for a few months. For such rainy days one should maintain an emergency fund in liquid savings that would cover living expenses of at least 8 months.
House and Car : House and car are the basic assets that one aspires to own. House is generally the biggest personal asset one owns and decisions regarding renting, buying etc should be taken after evaluating various alternatives. It should be in one’s financial plan to own a house debt free before retirement.
Life Insurance : If you have dependents then it becomes all the more crucial for you to take a life insurance policy.
Some safe investments in PPF/EPF etc and tax planning : Even if your risk appetite is high and age is less, you should still consider keeping some savings in a fixed return safe investment like a Provident Fund. This will also give you tax benefits.
Paying off Loans : Your financial plan being a roadmap should also state how you are planning to pay off your major long term and medium term loans such as student loans, house loans, car loans well before retirement.
Retirement and Estate Planning : Planning for retirement comprises of two hurdles. First, estimating the amount you would need on retirement considering inflation and other relevant factors. Secondly, choosing from various alternatives and deciding on which investment vehicles to use for retirement planning. Estate planning includes making a will and making nominees in all your investments so that your hard earned money benefits your family.
Investments : If investments are made after some research careful analysis they can really bear fruits and create serious wealth overtime. There are a lot of avenues for investing such as equity, mutual funds, other funds, commodities, bonds and government schemes etc all having different levels of risk and different rates of returns. You may select one or a combination of these avenues to invest in based on your age, time horizon, risk appetite and requirements. However, the riskier your investment, the more it needs to be monitored from time to time.
Other goal based planning : An individual has a lot of short term, medium term and long term goals in life for example, family holiday, child’s education, child’s marriage, house renovation etc. which are equally important and a comprehensive financial plan should enlist all the goals and the means to attain them.
This article only talks about the components in brief. To know more about each component read the detailed articles on each of them in this blog.
Step 3 : Assess your future needs
For each goal that you enlisted in the step above assess how much money you will need, when you will need it (i.e. time horizon). To evaluate how much you need to fulfill a particular goal in future don’t forget to consider the inflation and time value of money. For example, you need to save for your child’s higher education and will need it after 10 years. Today it would cost you Rs 10 lacs. Say the rate of inflation averages around 6% per year. Then to estimate what the cost of such investment will be 10 years later you need to use the following compound interest formula:
Future Value = Present Value ×(1+rate of inflation) ^ No. of years
Thus, education expenses after 10 years = 10,00,000 × (1+0.06)^10 = Rs 17,90,848
You should plan to save the inflation adjusted amount of Rs 17,90,848 for your future goal and not its present value of Rs 10,00,000.
Using the freely downloadable Personal financial plan excel file I have provided, you can easily calculate how much you need to save each month to reach the target for each goal.
Step 4 : Plan and allocate to your goals based on risk appetite
Once you have a clear idea of your goals, you allocate money and invest for them. For goals like insurance and paying off loans you can allocate monthly payments as per the scheme you chose. For other broader goals like retirement, education etc you have to decide on which avenues to use for investment. For doing this, it is very important to first analyze your risk appetite. As a rule of thumb the longer your time horizon is, the more risk you can take. However this can differ from person to person as per their willingness to take risk and also based on the nature of goal for which they are investing.
Avenues of investment that are more risky generally give you a higher rate of return. Below is a list of possible avenues of investment opportunities available in India based on risk, returns and liquidity.
|
Investment Avenue |
Risk |
Return |
Liquidity |
| Safe Investments like Bank FD, EPF, PPF, KVP, NSC, Post Office Deposits etc. | None to Low | 7% to 9% | High for FD, Low for PPF etc. |
| Bonds, Debt Funds etc. | Low to Medium | May vary | May vary |
| Equity, Equity based Mutual Funds and Commodities like Gold, Silver | High | May vary from very high to loss making | High |
| Real Estate | High | May vary |
Low |
You can choose to invest directly in the above avenues or invest in a mutual fund, ETF or insurance or pension schemes that invest in that avenue. For example, you want to invest in gold or money market bonds, then you also have the option to buy mutual funds or other schemes that invest in those avenues. However one should be careful and research the scheme well before investing.
For each goal attach a risk profile like high, medium or low. A balanced approach would be to invest 50:50 in lesser risk and higher risk avenues. However you may adjust it based on your goal risk profile. For example, if for a particular goal you are willing to take more risk then you can allocate 60% to risky avenues and 40% for safe one’s instead of following 50:50. A sample asset allocation for such a high risk goal might be 10% investment in liquid avenues like FD, 20% in bonds and money market funds, 20% in balanced (debt + equity) mutual funds, 15% in equity mutual funds, 25% in equity, and 10% in commodities or real estate. You will notice that the low risk avenues add up to 40% and high risk avenues to 60% in the above example.
On the contrary if you are a risk averse investor and want to plan for a low risk goal then your sample asset allocation could be 25% in safe avenues like FD or PPF, 35% in bonds and debt funds, 20% in balanced mutual funds and 20% in equity following a 70:30 ratio for safe : risky asset allocation.
The breakup of the percentages are discretionary provided you make sure to at least invest 10% in safe liquid investments and not more than 10% in highly risky channels like real estate unless you have reasons to believe otherwise. Remember, it is always better to be safe than sorry. The average weighted return based on rate of return from each avenue and amount invested in different avenues can be taken as the expected return from that goal the formula for which is given in the above mentioned excel file.
For smaller goals you don’t have to break up and allocate in numerous avenues like in the example above and investing in two avenues is enough. However, for bigger goals you should always diversify and invest in 3-4 avenues as discussed above so that you get benefit of both enhanced returns and stability and under performance of one avenue doesn’t lead to diminishing returns for your entire investment.
Download the following excel file to make your own financial plan following the above steps :
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