Steps of Financial Planning

Financial Planning is a step-by-step process and involves the following:

Step 1 - Identifying your goals and placing a time frame and money value to them.

The starting point for drawing up a financial plan is ascertaining your financial life goals. These life goals can come up in the next year or in the next 15 years. To successfully fulfill them, the key is to identify the time frame within which these goals need to be achieved and the monetary cost of fulfilling them.

What one needs to keep in mind is that while assessing the financial value of each goal, the time element needs to be considered. For instance, if one decides to buy a house after five  years, whose present value is Rs 25 lakh, the cost will increase due to inflation (here, we are ignoring the impact of change in real estate prices). If this house is to be purchased after ten years, the cost will be even higher than the cost at the end of five years (see the visual ‘Cost of a house over the years’). The rate of inflation assumed in this example is 5 per cent per annum.

Step 2: Estimating your earnings/receipts during your lifetime

It is imperative to draw a correct estimate of your present income and future earnings capacity in order to build on a sound financial plan. For this, you need to consider all your income streams – earnings from your employment or business/profession as well as returns generated from your present investments.

In case of the former, while assessing the income, you need to work out how your earnings will increase based on your present career status and future growth potential. In the case of the latter, the income will depend on the nature of that investment.

While computing your investment income, you need to take into account inflation. Inflation eats into your investment income and lowers the ‘real return’.

Real return = Investment return – tax on investment return – inflation.

Consider this. If your investment offers you a return of 6 per cent and the tax rate and inflation rate are 30 per cent and 5 per cent respectively, the real return on your investment is -0.8 per cent! Not only are you not earning anything on your investment, you are actually eating out of your capital. This is computed as shown below:

Step 3: Estimating and coping with the financial gaps

Once you have fixed a financial value to all your goals and projected your future finances, chances are that you may face a deficit (i.e. the cost of your financial goals exceed the amount available to fulfill the goals). This situation can be addressed in any combination of:

1. You can either re-align the cost of your goals downwards so that your financial plan is compatible with your earnings capacity

2. You can undertake a more aggressive investment strategy entailing greater risks but also earn higher returns

3. You can save more to generate higher wealth in the future

Step 4: Understanding your investment risk personality

All investment options carry risk. However, the degree of risk involved varies with the investment options. Higher risk is normally compensated by higher returns. However, a higher risk can also lead to loss of capital!

You need to be comfortable with your investments. Hence, before modifying your existing investments and/or making fresh investments, you need to assess your risk personality to understand the amount of investment risk you are capable of tolerating.

Step 5: Investing based on your risk personality

After determining your risk personality and the level of risk that you are willing to assume, you need to create your investment portfolio in sync with your risk personality. For this, you need to work out your asset allocation.

Your risk personality will determine your asset allocation i.e. how much you should allocate to equity and debt.

The next step would be to select specific equity and debt investments.

Step 6: Reviewing your financial plan

Your work does not end at creating the financial plan and undertaking the requisite investments. In order to make the plan successful, you need to constantly review and monitor it. This is because your goals and aspirations, circumstances, performance of the investments undertaken will change with time. Therefore, it becomes necessary to review your plan at regular intervals in order to provide for the changes that take place.




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