The Greatest Thing Money Can Buy is Financial Freedom
A COMPREHENSIVE NOTE ON FINANCIAL PLANNING
One of the most important if not the most important goal for most human beings is to achieve well-being and security for themselves and their loved ones. While money may not be a happiness impetus for everyone, a sound financial grounding surely gives you the power to provide for important life goals and live comfortably.
As you contemplate on figuring out the right financial map for yourself, we believe you could benefit immensely from this financial planning treatise we compiled by rigorously researching the global best practices in personal finance. These simple principles not only lay the foundation for meeting all your essential goals, but when followed consistently overtime can also serve as a reliable path to prosperity!
I. UNDERSTAND THE BASICS
Save, Save, Save! Contrary to popular opinion, the key to financial prosperity does not necessarily lie in your earning capacity but in disciplined savings. Dedicated and consistent savings over the long term is noted to be the single biggest driver of financial success. Thus, to assure long term financial well being for yourself and your family, you would be best served by cutting down on all unnecessary expenditure, stretching yourself to save maximum, and channelizing it towards efficient investment accounts. A prudent approach to follow for managing your finances would be to fix a monthly saving target and only spend what is left after saving and not vice-versa.
Automate Your Financial Plan
Often people delay their investment plans thinking that they first need to accumulate a size-able corpus for their investments to be meaningful. This usually turns out to be a costly financial mistake since the lack of a periodic investment commitment almost always weakens the savings discipline which prevents the accumulation of any investment corpus.
As opposed to this, a simple way to bring discipline to your personal finance habits is through forced monthly savings. You may impose this upon yourself by contributing to your investment accounts every month before you put your salary to use. This can be done by instructing your bank and/or investment broker to auto debit your account with a pre-set amount on the day of salary credit and directing the proceeds towards designated investment accounts. By implementing this process, you essentially force yourself to approach expenses as a residual of income minus saving! Overtime, these small automated contributions along with the investment returns turn into a size-able amount thus providing the foundation for meeting any reasonable future needs.
Understand the Power of Compounding
“Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it” --- Albert Einstein
The single most important investment comprehension which separates good investors from ordinary is the appreciation for ‘the power of compounding’. Put simply, compounding works because your return in every subsequent year has a higher base- the original amount plus the return on investment in the past years. For example, suppose Rs 1,00,000 compounds at the rate of 10%. Then in the first year, the return is simply Rs 10,000 which is the 10% return on Rs 1,00,000. In the second year however, your return would total Rs 11,000 which is Rs 10,000 (return on original investment) plus Rs 1,000 (return on the first year’s return of Rs 10,000).
This seemingly innocuous progression when repeated over long periods can create humongous difference in investment performance and exit value. There are two key financial practices which must be followed for the power of compounding to work in your favour:
a) Plan and investment for the long term since the magic of compounding grows with every year of investment tenure and is particularly favourable in later years.
b) Avoid taking debt (credit) especially for consumption expenditure because that means paying compound interest and the power of compounding working against you!
For any financial strategy to work successfully, it is important that the investments made in different accounts are allowed to run its full course and not withdrawn in an ad-hoc manner to cover for unforeseen expenses. Moreover, the main objective of financial planning is to live a stress-free life. Thus, it is essential to first cover the basic necessities before proceeding towards more ambitious goal setting. Two main elements in ensuring safety are:
a) Emergency Fund: the first step in financial planning is to set aside a certain minimum amount in a liquid account to be used in case of contingencies. Here, it is important to note that this money should be used only for emergencies like job loss, accidents etc. and not for any special purchases (fancy gadgets, car, holiday…)
b) Insurance: there is nothing more disturbing for a family than witnessing a medical condition or passing away of a loved one. At those moments, the most urgent need is to have the financial capacity to ensure the best medical treatment. In case of an unfortunate demise, while nothing can replace the emotional loss, an appropriate financial access can at least ensure that the remaining members of the family do not suffer a significant deterioration in their standard of living. Thus, covering your bases with a medical and life insurance where required is one of the most important financial action.
Focus on Fundamental Needs
The best way to build financial security for your-self and long term well- being for your family is through:
a) Home Ownership: owning a home has value not just for the emotional satisfaction and memories it creates but also because it provides a sense of stability and security. The comfort of home ownership allows a family to tide over difficult periods like recessions without a major disturbance in lifestyle.
Moreover, a home in itself is a valuable asset which appreciates overtime thus adding to overall wealth and social status. Often it is noted that for most people their best investment story is their primary residence. This is because there are some inherent features of home ownership (long term holding, leverage, tax benefit, forced savings through EMI) which are naturally inclined to produce favourable investment results. Thus, it would be wise to start at the earliest to accumulate the resources required for buying a primary residence.
b) Retirement Planning: the sine qua non of a quality financial plan is to sufficiently account for retirement needs! This is especially true in a country like India where social security system is clearly inept to provide for the financial and health care needs of the elderly. Given that you may not have the faculties or desire to earn after a certain age, it is imperative to carefully assess all your post-retirement needs and start investing early with a clearly devised retirement plan.
How Money Works
Having the resources to meet your goals is not so much about how much money you make but how much money you keep and how hard it works for you. The below illustration puts forth how disciplined savings from an early age coupled with the power of compounding can radically augment your financial capacity.
Suppose a young man named Mr. A (aged 25) wants to accumulate the funds to buy a home 15 years from now. He calculates that he can comfortably allocate Rs 50,000 annually (~Rs 4,000/month) to build his down-payment kitty and estimates he can earn 12% annually by investing in a portfolio of stocks and bonds. But he thinks it is too early to invest and he could delay his savings plan for a few years. Let us see how much corpus he can build if he chooses to invests now vs later.
We can see that by starting to invest an annual amount of Rs 50,000 immediately, Mr. A can build a corpus of Rs 20.87 lakhs by the age of 40 years, while a delay of 5 years can bring his corpus down to Rs 9.82 lakhs. In case of a further delay of 5 years, his accumulation drops to a paltry Rs 3.55 lakhs. Clearly the benefits of initiating an investment plan early are enormous. So, make your smartest move now and let your money work for you! Start saving early and gain from the snowball effect of compounding as it ticks in your favour.
II. PUTTING YOUR PLAN IN PLACE
Having understood the need and fundamentals of financial planning, we may next learn about the specifics of how to put your plan into action.
Creating An Emergency Fund
The main characteristic of an emergency fund is that it should be easily withdrawable and sufficient to cover most unforeseen expenses. In general it is believed that the size of an emergency fund should be equal to six times your family’s recurring monthly expenses including loan payments (EMIs) if any. However, in practice the emergency fund could vary between 3 months to 24 months of recurring expenses depending on individual circumstances and psychology. For example, people in high risk jobs need a higher safety net than those employed with the government while entrepreneurs and self-employed should have a higher emergency fund than those in regular jobs. The key determining factor is that the emergency fund should be such that you can sleep easy at night!
As is the case with all investment allocations, the best way to create an emergency fund is to automate it through dedicated monthly allocations in a separate account until it reaches the target size. Finally, emergency funds should be invested in low risk, highly liquid, interest bearing accounts- ideally a mix of savings account and money market instruments. Keeping all your emergency funds in your salary (savings) account is not a good idea since that could hamper spending discipline. Moreover, savings account generally pay very low interest rates. Since emergency funds are required to be maintained at all times, the total interest earned along with the compounding benefits from money market securities would be significant in the long run and should not be missed.
Being Adequately Insured
To decide on an appropriate insurance coverage, it is important to review your individual circumstances in detail and accordingly make an informed decision.
a) Health Insurance: the correct size of a medical insurance depends on your age, health condition, medical history of family, city, capacity to pay premium and desired quality of hospitals. Before buying a health cover, it is advisable to consult a medical or insurance expert who understands your personal and family requirement and can help you make a wise decision.
Much like all other aspects of prudent financial planning, the key again is to start early! Buying a health insurance early in life ensures a lower premium as you are likely to be healthier at younger age with a lower likelihood of pre-existing diseases. On the other hand, a middle-aged person needs to buy a higher coverage amount to account for the higher probability of ill-health and pre-existing diseases. Secondly, the cost of coverage increases with age and if the individual develops health issues, the insurance provider tends to exclude pre-existing diseases which defeats the very purpose of buying a health policy.
Given the variance in individual and family circumstance, there aren’t any widely acceptable rules of thumb. You may however take guidance from an indicative coverage chart as mentioned below.
Note: the above chart is based on average medical expenses at A-grade hospitals in tier I & II cities in India. It is suggested and appropriate only for a reasonably fit individual with no known family history of serious illness. In case of particular health condition or family history, the coverage should be suitably increased .
b) Life Insurance: for most of us, the primary reason to earn is to secure the livelihood of our loved ones. It is for this reason that covering yourself with a life insurance policy is an astute financial decision. The proceeds from such a policy can to a large extent ensure that the surviving members of a family remain financially secure even in case of demise of the primary breadwinner.
However, it must be noted that not everyone needs a life insurance. If you have enough assets to cover your debt and have no dependents or if the assets are enough to provide for your dependents after your death, then a life insurance plan is not required. Thus, it is advisable to consult a financial planner to understand if a life insurance is suitable for you and if needed, the correct amount that may be required.
The amount of insurance you need depends on age, family requirements and liabilities. Here again there are no thumb rules to understand the appropriate insurance amount, nonetheless a general guideline is that the sum insured should be enough to cover for all outstanding debt plus 10-20 times of your annual income depending on age. The insurance requirement is typically higher at young age and decreases overtime as you start accumulating assets and paying off your liabilities. Here again, like with other investment decisions, educating yourself is essential to making the right choice!
Paying Yourself First
The best way to organize long-term financial goals is to automate allocation of a certain percentage of your pre-tax income into designated investment accounts. As you proceed to choose specific instruments, it is important to note that tax efficiency and long-term growth are the key determinants of successful investment outcomes. While different people may have their own investment preferences depending on individual needs and psychology, we strongly advocate everyone to allocate some portion of their portfolio to the below mentioned instruments:
a) Government Backed Tax Advantaged Accounts: the government has mandated some very effective investment tools like Public Provident Fund (PPF) and Employee Provident Fund (EPF) which not only allow you to earn a risk-free annual interest of 8.0%-9.0% but are also placed under the most advantageous tax category of EEE. The EEE classification means the investment qualifies for a tax deduction at the time of investment (Section 80C), the interest earned is tax free and all the gains at the time of withdrawal are tax exempt!
We strongly recommend everyone to automate investing at-least 10% of their pre-tax income in these accounts every month. For most salaried employees such an automated system is already executed by their company to match the government’s mandate for EPF. Where this system is not in place, we strongly urge investors to make the requisite arrangement for allocating 10% of their pre-tax monthly income in either a PPF or an EPF account.
The long term, risk free (govt. backed) and tax efficient (EEE) nature of these investments make them one of the most effective if not the most effective tool for long term financial planning. Disciplined investments in these accounts can be targeted to meet most future liabilities (children’s education, retirement security etc.) while at the same time boosting the risk-return profile of your total investment portfolio.
b) Growth Plan via Equities (SIP): having put in place the basic building blocks of safety and tax efficiency in your financial plan, investors would be well served by including assets which boost the return attributes of their portfolio. Here, you could benefit immensely by judiciously investing in high growth assets like equities and mutual funds.
While investing in these assets, it would be advisable to consider your level of preparedness and education. As an average investor you are better off taking equity exposure through mutual funds or other pooled investment schemes (like PMS and ETFs) since these structures allow the benefits of professional management and diversification. Where you feel you have an edge for direct stock picking, it is imperative to avoid the temptation to over-invest in a single stock. This is especially important for those working for public limited companies where a familiarity bias or emotion can sway you to over-estimate the performance of your company’s stock.
Secondly, it would be advantageous to scatter your investments using a Systematic Investment Plan (SIP). By following this practice, you can avoid the dilemma of market timing while at the same time reaping the benefits of rupee cost averaging. This means that when we invest a certain fixed amount at periodic intervals in a volatile asset like equities, then naturally we acquire more units at a lower cost and lesser units when the prices are high thus lowering our average cost and boosting long term returns. Moreover, investing via SIPs automates our investments thus enforcing the practice of disciplined monthly savings.
Buying a Home
Though the wisdom of buying a primary residence is well established, the decision on making the right purchase can be complex and at times overwhelming. Given the large capital commitment that a property demands, it is important that buyers have the right financial framework for making a sound decision. The key here is to carefully asses your financial capacity and arrange optimal financing.
Most buyers purchase their home using a bank loan which typically finances up to 80% of their property value. Irrespective of how much loan a bank is willing to sanction, buyers should carefully assess their own repayment capacity and accordingly decide on a suitable budget. To evaluate your loan repayment capacity, you should not only consider your income but also your age and the stability of your job. One should also attentively examine monthly expenses as well as willingness and scope for skimming monthly budget to accommodate additional EMI payment. In deciding your budget, it is also important to factor in the costs beyond mortgage expenses like set-up costs (furniture and décor), maintenance fees and utility bills.
Additionally, one should also recognize individual parameters like career prospects and psychological comfort with loan amount. Though it is difficult to provide a thumb rule for the correct loan size given the multitude of personal parameters involved, an EMI to net monthly income (after tax and PF deduction) of 40%-60% is considered suitable for most people. For those who are young and have good career prospects, they may stretch themselves towards the higher end of this range. Remember a home loan is a ten to twenty years commitment. Thus, if your income can be reliably expected to increase materially in the near future (1-5 years), it would be prudent to live tight in the short-term and pay a higher EMI to enjoy the long-term benefits of owning a great property!
In terms of arranging the resources for making the down-payment (self-contribution), here again starting early and automating the process though dedicated monthly allocations to a separate account would be an efficient way to proceed. To reduce the time required to accumulate a decent down-payment amount, one could also consider channelizing a lion's share (about 70%) of the yearly bonus (variable pay) towards the down-payment kitty until the target number is achieved.
Preparing for Retirement
In preparing for retirement, it would be provident to follow the below guidelines:
a) Start early with a consistent automated allocation: starting early allows you to increase the investment time horizon and leverage the power of compounding. Besides, a longer period also makes it feasible to invest in risky and high growth assets like equities and MFs which can help accumulate a large post-retirement corpus.
b) Proper Assessment: given sensitivity of being financially secure during old age and the fact that everyone has their unique requirements and liabilities, it is crucial to properly assess all your objectives and constraints via a Dedicated Retirement Plan. A well thought out plan diligently incorporates your goals, risk appetite, time horizon and accordingly defines appropriate investment strategies to achieve them. Any unrealistic expectations or gaps in investment education are also plugged at the initial stage itself.
In deciding on a suitable contribution, one must factor in a reasonable rate of return that can be earned and the corpus needed to support post retirement expenditure. While estimating the required corpus, it is important to account for not just the running expenses but also an emergency fund, old age medical costs as well as a suitable rate of inflation.
c) Choose the Right Instruments: to lead a financially secure post retirement life, it is imperative to earn a rate of return that comfortably exceeds the inflation rate. While traditional instruments like bank FDs and PPF offer safety of investment, the relatively modest returns on them may not be adequate to build a desired post-retirement corpus. Equity investments on the other hand are a good inflation hedge and when combined with fixed income instruments in a well-diversified portfolio can provide the best risk adjusted returns in the long term. A higher return also implies that an investor has to invest lower initial amounts to achieve the same capital outcome.
III. BEING ON TOP OF YOUR FINANCIAL GAME
Much like all good things in life, maintaining a good financial hygiene is fundamental to good financial health! To maximize your gains with personal finance, developing good financial habits as mentioned below will go a long way in augmenting the efficacy of your investment plans.
Get Rid of Debt
Debt is to finance what junk food is to fitness! It is tempting and pleasing to take but leaves you with unwanted weight which is harmful and difficult to shed. Thus, developing a habit of never taking credit for consumption and cutting all flab (debt) early keeps you in good shape for the rest of your life.
To build on this habit, we would suggest to never take a personal loan or keep a credit card outstanding. These can form addictive splurging habits which are hard to change. Moreover, these forms of credit have very very high interest rates (often upward of 20%) and can severely erode your capacity to accumulate any savings. If at all a credit card is to be maintained, keep its usage to minimum and mentally account for it like a debit card. This means, every time you transact using a credit card, you should have the requisite amount in your savings account to clear it off as if you needed to do it immediately.
In case you have a credit outstanding, immediately discontinue your credit card and negotiate with the card-loan provider for closing the debt. In case you do not have the resources to square off the debt at once, we would suggest prioritizing being debt free over making other investments. So, you would be well advised to direct 50%-100% of your automated monthly savings for offsetting the outstanding credit until its paid off completely.
Note: the above emphasis on not doing debt is focused on debt for personal consumption. However, where debt is required for personal growth like quality higher education or purchasing a primary residence, a moderate and well thought out debt plan is considered an intelligent exception to the rule of ‘no credit’.
Pay Off Your Home Loan Early
As an omission to the principle of debt avoidance, because of the numerous benefits of home ownership (tangible asset, tax benefits, levered returns, rent avoidance etc.), buying a home on credit is usually a good idea provided the buyer has put in place an emergency fund and the monthly EMIs are manageable. At the same time planning to keep interest costs minimum and paying off the loan at the earliest are key to maximizing the gains from your property purchase. You may optimize your loan repayment by stretching yourself and following one of the below repayment methods:
a) Pay 10% extra on your EMIs each month and make sure the extra payment goes out to reduce outstanding balance.
b) Pick out one month each year when you pay double your monthly EMI and the extra amount is used to set off outstanding principal amount.
c) Split your EMI amount into half and make bi-weekly payments instead of monthly payments. This is a an excellent mathematical trick which has the effect of accelerating interest payment payments and bringing down outstanding principal marginally every month. When practiced over a long period, these marginal benefits can add up significantly to reduce the total cost of home ownership.
By following any of these repayment styles, you in effect cut down on your total interest outgo over the life of the loan and can close your home loan 2-7 years before schedule depending on original loan tenure and amount.
Keep Your Expectations Reasonable
As you proceed on your journey towards financial freedom, it is important keep yourself continually educated and be reasonable in your expectations. Most importantly it would be helpful to develop a good understanding of historical returns of different asset classes. You may note that on average, the long-term returns from Indian equities have ranged between 12%-18% depending on time horizon and investment strategy. At the same time returns from fixed income instruments have varied between 7%-12%. Though there is no decisive data on Indian real estate but one can reasonably estimate the long term returns (10-30 years) from real estate to be roughly 10%-15%.
Note: The recent slump in residential real estate notwithstanding, the long term returns (over 10 years) from real estate are still extremely favourable. Besides, commercial real estate with an average rental yield of 8% and a growth of 5%+ (usually marked to inflation) has continued to provide handsome total returns (12%+) even in the overall slow realty market.
Using these returns as guideline, it can be inferred that it would be difficult for an average investor to consistently earn a return greater than 12%-15% unless you allocate a large chunk of your portfolio to equities (or real estate) and are either skilled enough or lucky enough to outperform general market trends. Secondly, it is essential to understand the tradeoff between risk and return. In investments, higher returns are often associated with higher risk. This means assets with potential for higher returns are also more volatile and may see temporary or permanent decline in value. While the allure of generating high returns from equities can be tempting, the inherent risks associated with stock markets means that one should be measured and thoughtful in deciding an appropriate equity exposure. Similarly, the higher returns in real estate as compared to fixed income also come with higher relative risk.
Given the limitations of market returns, it is crucial that you are balanced in framing your expectations from your financial plan. In case you desire a large future corpus for meeting your requirements, the solution is to increase your contributions or starting early, perhaps both. Where this is not possible, you would be well advised to prune your future needs rather than hoping for unrealistic or magical returns.
Hold a Diversified Portfolio
Before you commit to making any investments, it is important to assess your appetite for risk and comfort with potential downsides. As detailed earlier, equities which provide the highest returns come at the cost of additional risk. On the other hand, fixed income instruments safeguard your principal and provide a regular stream of income, but the relatively lower rates of returns from these instruments may not keep up with inflation over time. To balance the twin objectives of minimizing risk and maximizing returns, it is advisable to have a well-diversified portfolio. While equities provide growth and a cushion against inflation, fixed income instruments balance the risk by providing stability and regular income at lower levels of risk.
Stock markets historically have trended higher over the long-term despite brief periods of extreme declines. When you diversify and invest for the long-term, volatility does not pose any major threat to your investments. This is because diversification ensures that you are invested in securities and assets which have low correlation with each other. So, all your investment constituents do not decline or increase in value at the same time thus lowering the volatility and hence riskiness of your portfolio. In the long term, this optimizes your investment results as you get higher return per unit of risk.
In general, equities and fixed income instruments are the most common investment tools used by the average investor. The right combination of these two assets would suffice in most situations. However, we recommend investors to also educate themselves on other assets like commodities and real estate. In particular, Gold has been noted to provide a source of uncorrelated returns and tends to outperform during period of global crisis and rupee depreciation. Thus, holding some gold (5%-10%) in your portfolio is a prudent choice since it can enhance the long-term risk adjusted return on your capital.
Also, where investors have a large invest-able corpus, they may consider taking some exposure to real estate. Quality real estate tends to appreciate overtime and is an effective hedge against inflation. Depending on category (residential, commercial), it provides a rental yield of 3%-10% which not just boosts total returns but also provides an excellent source of passive income. This additional income can be very beneficial in times of need like during retirement.
Re-balance Your Portfolio as Suitable
Having understood the risk-return characteristics of different asset classes, we may note that portfolio construction should not be a static event. Although unnecessary churning is never advisable, being aware of market dynamics and changing personal needs is crucial in maintaining the right portfolio structure.
In general, the right asset allocation depends on your time horizon, future needs and risk appetite. This in turn is a determinant of your age and market conditions, both of which are dynamic variables. When you are young, you naturally have the benefit of a longer time horizon. Also, you have the earning ability to recover from portfolio downturns and make lifestyle adjustments if required. Thus, it is beneficial to allocate more towards high growth assets like equities early in life. And as you approach retirement you may steadily lower the allocation to equities and turn towards the relative stability of fixed income instruments. A simple rule of thumb for portfolio construction for individuals is to allocate 100 minus their age to equities while the remaining may be distributed among-st the safer assets like PPF, bank FD’s, government bonds etc. For example, if an investor's age is 32 years, she should allocate 68% (100 - 32) of the funds to equities and invest the remaining in fixed income products.
Secondly, investors should also be mindful of market conditions in making suitable portfolio decisions. An assessment of historical market trends across all assets reveals that asset prices tend to move in cycles. The stage in cycle is also linked to short term riskiness and near-term price movement. Typically, when an asset has seen a strong run-up in prices, it tends to get over-priced and may be due for a correction. In situations where the price upswing is overstretched, investors would be well served by being cautious and not make large investments at this stage. As prices cool to more moderate levels, one will surely get an opportunity to make the desired asset allocation at more acceptable prices!
Finally, investors should periodically monitor their portfolio to correct for large divergences from pre-decided asset allocation. When a particular asset class has outperformed others for a certain period of time, the portfolio can get skewed towards a higher than desirable weight-age for this asset. When this happens, it is beneficial to re-balance your portfolio to its original asset proportion. Such periodic re-balancing based on price asymmetries of assets aligns the portfolio with your long-term risk-reward goals. Also, it automatically in-builds the practice of ’buying low and selling high’ thereby enhancing the long-term performance of your investments.
A lot us believe that the route to financial fulfillment lies in continually enhanced earning potential. While the disposition to chase your ambition and strive for higher income is surely a valuable attribute, a perceived gap between earnings and desires may not necessarily be a limitation.
A little education, a bit of stretch and a thorough commitment to disciplined savings can give you the financial power to achieve all your goals. By starting early, buying a home and automating your investments, you certainly can make the rest of your life, the best of your life! Good Luck!