Importance of Financial Planning

Dec 12, 2016 / Dwaipayan Bose | 101 Downloaded |  11269 Viewed | | | 3.5 |  16 votes | Rate this Article
Mutual Funds article in Advisorkhoj - Importance of Financial Planning
Picture courtesy - PICJUMBO

We believe that every financial decision in our life should be based on some goal. The goal can be building a retirement nest egg, saving for your children’s college education or wedding, saving for a down-payment for property purchase, protecting your family from financial distress due to unforeseen risks, protecting your family from health risks, protecting your home or business from fire or other hazards etc, but unless you have an objective, you will not be able to make the right decision. Financial planning, whether formal or informal, is a process where you define your goals in quantitative terms and then, formulate a plan which will help you meet all the different financial goals in your life.

Financial Planning

Financial planning is no different from a structured problem solving framework. Every structured business problem solving exercise has 5 specific steps (the same can be applied in financial planning as well):-

  • Clearly defining the problem (in the context of financial planning, identifying your goal)

  • Defining success criteria (in the context of financial planning, quantifying the goal, determining the goal horizon, understanding the risk tolerance level and other important parameters that define success)

  • Analyzing the current situation (in the context of financial planning, understanding your income and expenses, assets and liabilities, risks and opportunities, asset allocation etc)

  • Evaluating multiple alternatives / solutions (in the context of financial planning, evaluating multiple asset classes, product classes, schemes, plans etc)

  • Selecting the best solution (in the context of financial planning, from risk / return, liquidity, tax etc perspectives) and executing it in the most efficient manner

Benefits of Financial Planning

  1. The first step of financial planning is to define specific goals. The more specific the goals are the better. As an investor, especially if you are young, you may not have enough clarity about all the financial goals in your life. This is where an expert financial planner or adviser can help you. He or she can help you define the goals across your savings and investment lifecycle. He or she can then, help you determine the specific quantitative targets you need to reach the specific goals. Your financial planner can help you to determine, how much you need to save and invest each month / quarter / year to meet your goals.

    You should know that, any financial plan is based on certain assumptions. These assumptions can and will change over a period of time. How you define a goal success (changes in lifestyle, your personal situation) also changes over a period of time. Therefore, a financial plan is not static, but dynamic in nature. A well thought out financial plan is, however, key to meeting your financial objectives. Without a financial plan, you are at the risk of falling short of your financial goals.

  2. Budgeting is the next step of financial planning. This is probably the most important step of financial planning, but also the most ignored one. Even if you have the most detailed and well structured financial plan, if you are not able to save enough, you will not be able to meet your financial goals. Saving habits are very personal, depending on your lifestyle, relative to your income levels. The objective of a good financial plan is to enable you to meet financial goals, without having to sacrifice the lifestyle commensurate with your income. Different individuals and families have different spending habits, relative to their income. People who have monthly budget are more likely to be in control than the people who do not have monthly budget. These people are further down the track in meeting their financial goals.

    While financial planner or adviser may not actually prepare your budget, he or she can help you give you guidance on how to prepare one. Budgeting is not a hugely time consuming exercise. While preparing your budget, you should try, as much as possible, not to skip minor details, because through a careful budgeting you may be able to identify expenses, which you can easily reduce, without any noticeable impact on your lifestyle.

    Remember, even a small additional savings can make a big difference to your long term wealth, with the help of power of compounding. Just to give you an example, even an additional Rs 500 monthly savings, invested in equity assets yielding 20% return, will generate a corpus in excess of 1 Crore over 30 years.

  3. How you invest your savings (debt or equity or real estate), plays a very important role in ensuring the success of your goals. Different asset classes have different risk return characteristics. Too much risk can result in loss of money, while too little risk may prevent you from meeting your long term financial objectives. Asset allocation is the process of balancing your risk and return objectives. It is one of the most important aspects of financial planning. A financial planner or adviser will provide guidance to investors with regards to their asset allocation strategies, in order to meet their short term, medium term and long term financial objectives.

  4. Having a financial plan helps you prepare for risks. Risks are unforeseen events that can cause financial distress. The worst case contingency is an untimely death, which can result in financial distress for the family, apart from the emotional trauma. Financial planning can help us prepare for such contingencies through adequate life insurance. Another contingency is serious illness that can have an impact on your savings and consequently your short term or long term financial objectives. A good financial plan will make adequate provisions for health insurance. There can be other contingencies like temporary loss of income or major unforeseen expenditures. Financial plans will help you prepare for such contingencies.

  5. Tax Planning is another important aspect of financial planning. When you have income, you come under the ambit of tax. Tax planning starts when a person starts working and continues almost through-out one’s life, even after retirement. Different investment products are subject to different tax treatments. Financial planning can not only help you save taxes (under Section 80C, Section 80CCD, Section 80D etc) every year, it will also help you reduce the tax you have to pay on your investment income or profit. Mutual funds are among the most tax efficient investment products and therefore, preferred by most financial planners for long term investments.

  6. Financial plans early in your working careers will give you a head start in meeting your financial objectives. Saving and investment is not the most important priority for many young professionals. While lifestyle is an important consideration for many young people, you should be careful to not build a liability in your personal balance sheet. Economic lessons learnt from the west over the past 2 decades have taught us that we can easily get into debt trap without even realizing. Young people should think long term, because a small amount of money saved now can create wealth for you in the future. Having a financial plan earlier in your work career will put your savings and investment on autopilot mode, with minimal impact on your lifestyle.

    You will realize the benefits of early financial planning, when you approach important life goals, like buying your house, funding your children’s higher education, your own retirement etc. Early start can also help you buy adequate life and health insurance at much lower cost; premiums rise rapidly as your age increases. Financial planning and investing is often a daunting task for young people. You are not sure about your specific long term goals. This is where an experienced financial planner or adviser can help you.

Conclusion

In this article we have discussed, how personal financial planning can help you meet your short term, medium term and long term financial objectives. You can engage a financial planner, to prepare your financial plan and implement it. However, you should remember that, the effectiveness of your financial plan will depend on the level of your engagement in the process. In our next article, we will discuss some important steps in the financial planning process.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.

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