Components of a Financial Plan
Financial planning is often confused with investment planning. Although investment planning is a major part of financial planning, it does not encompass the entire concept. There are several more components to financial planning as well. In this article, we will have a closer look at the various components of a financial plan.
Budgeting: A lot has already been said about budgets. It is an integral part of any financial plan. However, it is important to note that from a strategic point of view, a budget is a very short term in nature. The contents of a budget statement are generally valid for the next month or next year. After that, the old budget is compared with actuals, whereas the new budget is created once again. Hence, from the point of view of personal finances, the purpose of a budget is to provide short-term financial stability, i.e., solvency to the investor. The basic idea behind the budget is that money coming in must be more than the money going out every month. Very short term goals, such as shopping or vacation, should also be a part of the monthly budget. It is a good practice to set money aside for these goals each month and then spend the corpus when the time is right.
Liquidity Management: The budget helps an investor fulfill their extremely short term goals. However, there are certain expenses for which any person does not set up a goal. These include unexpected expenses such as repair bills and other unforeseen circumstances. These things happen to everyone in life. However, if a person is not prepared for these events, then they may end up pushing a person into a debt crisis. This is the reason that another major component of the financial plan is the liquidity plan, wherein a certain amount of money is set aside to meet unforeseen events. This might seem like a very simple thing to do. However, it is surprising to know how many people are invested in long term illiquid assets without having any sort of short term liquidity. The end result is that a lot of these people end up using credit cards, and this is often the beginning of a usurious debt trap.
Insurance: Insurance is a very important and often neglected part of financial planning. This is because, in the short run, insurance is often perceived as an expense and hence is relegated to a lower priority. However, seasoned investors know that they are paying for financial protection in case something goes wrong with their lives. The number of people who are sick and end up in hospitals every year is increasing. Also, since the costs of medical care are skyrocketing, a lot of these medical emergencies end up turning into financial catastrophes. Ignoring insurance can be a very expensive mistake and can deplete the life savings of any person.
Financing Large Purchases: Every person has to make certain very large purchases in their lifetime. These purchases include house purchases, vehicle purchases, college education, etc. The transaction value of these purchases is so high that they are often measured in multiples of their annual income. These purchases can be financed by their own money or borrowed money. Typically, they are financed by a mix of the two, with their own money being used for down payments while the rest is borrowed.
Saving for large purchases typically form part of a medium-term goal. The money which needs to be saved needs to be deployed in such a way that it earns a higher rate of return than a regular savings account. However, one has to also ensure that the money saved is safe and that the return of capital itself is not jeopardized.
Financing large purchases are complex, and several other factors need to be taken into account. Firstly the proportion of the monthly income which goes towards paying these expenses needs to be taken into account. There are certain thumb rules about how much debt it is advisable to take. Secondly, one also needs to take into account that these payments can be variable. These payments are based on the interest rate, which fluctuates in the short and long run. Hence it is advisable to build some buffer into the financial plan.
Long Term Investment: This is the part that is often focused on when we refer to personal finance. People often discuss whether they should invest in debt or equity. Also, once they choose an asset class, they also discuss whether mutual funds would be a better way to reach their goals as compared to index funds.
There are many ways to achieve long-term investment goals. This is evident from the many books which have been written on the subject. However, some basics remain the same. For instance, diversification builds protection into the portfolio. Hence, an investor must not keep their portfolios too concentrated and must instead try to widen their scope. Also, any money that may be required within a period of five years should not be in the equity market. The high volatility of the market makes it worth investing only if the investment horizon is large.
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