Overview of financial planning 

Financial planning helps in understanding the relationship between the four elements of the personal finance situation of an individual: income, expenses, savings, assets and liabilities.

• Income: Income is primarily derived from two sources: Income from profession or business or employment undertaken.  Income and earnings from assets or investments such as rent from property, interest from bank deposits, dividends from shares and mutual funds, interest earned on debentures.
• Expenses: Income from business/profession is utilized to meet the basic necessities which form a part of expenses.
• Savings: After meeting personal expenses, the surplus income left with individuals is savings which is then converted into assets or investments earning a future income.
• Assets and Liabilities: Large assets such as real estate or cars might require accumulating the above surplus income for a long time in order to make large asset investment. Whereas accumulated savings may also be used to pay off liabilities in the form of loans.

Financial goal is the term used to describe the future needs of an individual that require funding. It specifies the sum of money required to meet the need when it is required. Identifying financial goals help to put in place a spending and saving plan so that current and future demands on income are met efficiently.

Savings and Investments: The funds required for financial goals are accumulated out of savings made from income. These savings can generate further income and appreciate in value over time by way of investments. For example, Arvind requires Rs. 20,00,000 to pay the down payment on a house. He is able to save Rs. 10,000 each month.

• If he keeps his savings of Rs. 10,000 in a box, he would need 16 years and 8 months to accumulate the funds.
• If he puts the Rs. 10,000 each month in deposit that earns 10% per annum, he will be able to accumulate the funds in 9 years and 10 months .This feature of investment implies that time required to accumulate the funds required will be lower.

For example, Arvind wants to accumulate Rs. 20,00,000 in the next five years to make the down payment on a house.

• If he keeps his monthly savings in a box, he would need to save Rs. 33,333 each month to reach the sum required.
• If he puts the savings each month in a deposit that earns 10% per annum. He will be able to accumulate the required sum in five years by saving Rs. 25,000 each month. This feature includes the amount required for monthly savings is lower in an investment.

Investing is the activity of employing money in buying assets so that it generates income and appreciation in value over time.

Money can be invested in different assets such as equity, debt, gold, real estate and cash. Each of these investments will have different features on the nature of the return generated, the risks to the return and the liquidity that the investment provides.

Features of return on investments

• It may be in the form of regular return and capital appreciation.eg. equity shares and dividend received, real estate property and rent received from it
• May not have regular return but only capital appreciation. For example, Gold investment having its prices appreciated but no regular return.
• Guaranteed income, for example bank deposits have fixed rate of return
• Variable income, for example equity shares return can vary
• Known in advance and fixed.eg. debentures generate fixed income and some capital appreciation as well.∙

An investment may be seen as risky if:

• There is a possibility that the capital invested may depreciate in value.
• The returns expected may not materialize
• The returns generated may be inadequate for the goals

An investment may be seen as illiquid if:

• It cannot be redeemed or sold easily when funds are required
• The value that can be realized on sale or redemption is lower than its correct or fair value
• It can be liquidated only as a whole, irrespective of the need for funds
• The costs related to liquidating the asset may be high

Span of investments:

• Higher the risk the investor is willing to take, higher will be the return that is earned.
• Investments that give high but volatile returns need sufficiently long investment horizon for volatility to smoothen out
• If a risky investment fails to deliver as expected, a long investment horizon gives the time to make changes and catch up.

Steps in Financial Planning

Financial planning is the process of managing personal finances so that the current and long-term financial needs are met in the best possible way. It involves looking at the current income and expenses, identifying demand for money for meeting the goals and making a saving and investment plan that considers the current and future income, expenses, assets and liabilities.

Identifying Financial goals: Goals described in terms of the money required to meet it at a point of time in future, is called a financial goal. Converting a goal into a financial goal requires the definition of the amount of money required and when it will be required. example: Rs. Three lakhs required after 5 years for a foreign holiday. Rs. Seven lakhs required after three years as down payment for a house.

There are two features that distinguish a financial goal: value of the goal and time to goal.

• Value of the goal: This is not just the amount or cost of the goal at present but is the amount of money required for the goal at the time when it has to be met(future value). The amount of money required is a function of current value of the goal, Time period after which the goal will be achieved, Rate of inflation at which the cost of the expense is expected to go up
• Time to Goal or Investment Horizon: Financial goals may be short-term, medium-term or long-term. Time to goal refers to the duration of meeting the goal. If the goal is short-term, low risk investments will be preferred even though the returns will be low since the investor would not like to take a chance of losing the principle and return on the, amount invested. As the time available for the investment increases the investor will be able to take higher risks for better returns.

Assessing Current Financial Position: Once the financial goals have been identified, the next step is to assess the current financial position to determine how the goals will be met. The ability to save for future goals will depend upon the current level of income and expenses, and how much of the current income will be used to pay off liabilities (debt), only then true savings can be assessed. In addition, the existing assets and investments will also be taken into consideration while assessing current financial position.

Funding the goal: After assessing the financial position, savings and investments available to meet the financial goals, the next step is to assign the savings and existing assets to the goals so that the funds required can be accumulated over time. The amount of savings that will be assigned to a goal will depend upon the value of the goal, the time available to reach it and the type of investment selected to invest the savings. For example, In an equity investments the amount of savings to be set aside is lower than in a bank deposit since the risk in equity is higher and returns are also proportionately higher .

Example : Madhur is saving for a car and requires Rs.7 lakhs at the end of five years. He has the option of investing the savings in equity which is expected to give him 15% return or a bank deposit that will give him an 8% return.

If he decides to invest in equity, he will require investing Rs.7902 each month to be able to accumulate the funds. If he chooses to invest in a bank deposit he will have to invest Rs. 9526 each month since the returns are lower.

If he increases the time available to 7 years, he will need to invest only Rs. 4757 each month in equity and Rs.6243 if he chooses a bank deposit. This is because there is a longer time available for the savings to appreciate to the required sum.

The investment decision depends on the time available before the goal has to be met and the ability of the investor to take risks. If the time available to meet goal is long, equity investments should be made since it has high volatility in the short run which requires time to smoothen out and start giving high returns in long run. Although if an investor is risk averse even though in long run equity might perform better, he might want to opt for deposits since it has no risk involved. In such cases the amount to be saved needs to increase in order to meet goals in time or the time to reach the goal can be extended.

Review and rebalance: The investments made for the goals will require to be reviewed periodically. The review is necessary to answer the following questions:

• Are the goals on target for achievement in the required time frame?
• Are the investments performing as expected?
• Do the investments need to be changed if it is no longer suitable for the goal?

For example, Jayant has been saving for the education of his children for the last 8 years by investing in equity. The goal has to be met after 4 years now. Jayant would not want to leave the funds that have been accumulated in equity any more since there is a risk that the fluctuation in equity values will affect the amount that he has accumulated so far. Jayant would be ready to move the funds to less riskier investments at this stage.

Review of the portfolio of investments has to be done at least once a year as part of the financial planning process.

Asset Allocation and Diversification: An individual creates a portfolio of investments to meet various goals. The investments selected have to balance the required return with an appropriate level of risk for each goal. Investor may have various requirements from an investment i.e. growth for long-term goals, liquidity for immediate needs and regular payouts to meet recurring expense. One investment cannot fulfill all the requirements which is why a portfolio of various investments is created based on investor needs. If an investor’s portfolio contained investment of only one type say equity, fall in equity markets will lead to an overall fall in the investor’s portfolio, whereas if investor’s portfolio contained investments in equity, debt, gold etc proportionately, then a fall in any one investment will not impact the overall portfolio to great extents. This process of dividing the portfolio among different assets so that the overall portfolio’s return is protected from the effect of a fall in one or few assets is called asset allocation. The asset allocation that is suitable for a person will depend upon their specific situation. For example, a person close to retirement will have a higher allocation to safer investments such as debt and lower allocation to equity. On the other hand, an individual in the high income period whose goals are far away will prefer to earn higher returns with assets such as equity rather than lower risk assets with lower returns.

Diversification means creating a combination of different assets or investments in such a way that a rise or fall in one asset does not lead to rise or fall in the overall portfolio. The benefit of diversification will be available to a portfolio only if the selection of investments is done with care so that they do not rise and fall together.

• Allocating between different asset classes, such as equity, debt, gold, real estate, is the first level of diversification.
• At the next level, within an asset category looking for investments that will not move together will benefit the portfolio. For example, while investing in equity, if shares of companies in different industries are selected then the diversification benefits are higher since the fall in prices will not be identical across all industries.
• Asset allocation and diversification reduces the risk of loss in a portfolio and stabilizes the returns that the portfolio generates.

Investing for Financial Planning

• Managing Return and Risk requirements: Implementing a financial plan requires decisions on where to invest so that goals will be met in time and risk associated to be managed by diversification.
• Align portfolio features to investor needs: The financial plan may require focus on growth, income and liquidity at different stages in the investing life of the investor. For example, saving for retirement will require the portfolio to be focused on growth in the years when the funds are being accumulated. Once retirement is reached, the retirement portfolio will be inclined towards income. It must be easy to rebalance the investments to be aligned to the current needs.
• Ease of investments and exit: Investments used for financial planning must be convenient such that it enables investors to invest periodically as and when they generate savings and surpluses. It must be flexible enough to allow exit in case of an emergency or if rebalancing of portfolio is required. Thus Investments must be capable of being liquidated easily whenever the investor may need to do so.
• Flexibility in investments: Investments should be flexible to allow investors to structure returns to suit their specific requirements. For example, a low risk investor may choose a mutual fund Monthly Income Plan (MIP) as a lower risk debt-oriented fund even though regular income may not be required. A growth option in the fund is a convenient way to invest in it without having to take periodic dividend when income is not required.
• Information and Updates: Investors must be able to get information about the investment regularly so that they can assess the performance and suitability of the investment. Securities are issued under specific regulations which typically require the investors to be provided with adequate information.