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  • Writer's pictureAkshay Nayak

Five Star Financial Advice

Those of us who intend to work with financial advisors or are already doing so must keep one thing in mind. Most advisors present their thoughts to us with so much conviction that we tend to believe in every word they say and their approach to imparting advice instantly. But this can sometimes be detrimental to our financial wellbeing. It is therefore important for us to be able to discern the difference between sound financial advice worth following and errant advice worth ignoring. Let me first say that financial advice that views investing as the only problem individuals need to solve rather than viewing it as a solitary component of a broader, more holistic solution should be completely ignored. And the same holds true for advice that places primary focus on selecting products and then aligns various aspects of personal finance to the products chosen. Sound financial advice on the other hand is driven by five interconnected facets. In today’s post I’m going to throw light on each of these aspects individually and show how they fit into the process of imparting sound financial advice.

The first facet that sound financial advice involves is that of goal setting and quantification. This particular facet assumes significance in a number of ways in the process of imparting quality advice. It helps those who lack clarity on their financial goals by helping them realise what their financial goals should be. Those who have a number of financial goals they wish to achieve would be well served by this exercise since it would help them understand which of their financial goals are worth working towards and rank such goals in order of importance. Helping clients prioritise their financial goals would mean that they would not reconsider them repeatedly. It also makes it easier for them to achieve all their goals by effectively employing the resources that they currently have with them. Quantifying financial goals involves budgeting and estimating the cost of each financial goal. This in turn helps in setting an end point with regard to planning for each individual financial goal. The process of goal setting and quantification can be understood by looking at the graphic below.

Imparting quality financial advice also involves helping clients estimate their insurance needs. High quality financial advice must help clients understand their insurance requirements at multiple levels. Health insurance is a basic and pervasive requirement for all clients and their families. Health insurance needs must be assessed based on the prevailing healthcare costs in the region where each client and their families reside. On the other hand, life insurance would be a mandatory requirement only for those members in a client’s family who earn an income for the family. Therefore, estimating life insurance needs also involves an element of assessing household income. The amount of life insurance required is usually set as a certain multiple of a client’s household income. Lastly in case of clients who are the sole breadwinners in their families, it makes sense to purchase adequate disability insurance along with life and health insurance. It would serve as a safety net in the event of income stoppage due to temporary or permanent disability.

The next facet that is indicative of high quality financial advice is that of assisting clients with regard to risk profiling and asset allocation. Financial advice that is imparted on the back a comprehensive risk profiling test adds a great deal of value to clients. It ensures that the advice given to clients is contextual and well aligned to the financial realities of each individual client. This would ensure that clients are comfortable following the advice given to them. Sound financial advice must also help clients zero in on the ideal asset allocation strategy for their needs. This is a critical aspect in the process of imparting advice since the asset allocation strategy would dictate the structure of clients' portfolios.

Asset allocation strategies must be dictated by clients' risk profiles. But they must not be aligned to either extreme of the risk spectrum. A highly aggressive asset allocation strategy may deliver handsome returns for clients, but the risks involved may make it difficult for them to stick with such a strategy over long periods of time. On the other hand, a highly conservative asset allocation strategy places greater emphasis on safety allowing clients to comfortably stick to their strategy. But the returns from such a strategy may not be enough to help them achieve their financial goals. Therefore, the ideal asset allocation strategy must be comfortable enough for clients to follow consistently and generate satisfactory returns on a sustainable basis. It must also provide clients with enough room for liquidity to enable them to create an adequately sized emergency fund. Also, care should be taken to see that clients' portfolios are not lopsided thanks to a heavy allocation to a particular asset class. Finally, sound financial advice must give clients a set of guidelines to rebalance their portfolios periodically based on preset criteria. To understand asset allocation as a whole at a glance, look at the graphic below.

If clients' asset allocation strategies dictate the structure of clients' portfolios, the products they select fill out that structure. Therefore, after an adequately sized emergency fund has been created, high quality financial advice must help clients make the right product choices that are well aligned to their asset allocation strategies. And this is the fourth facet of sound financial advice. Product choices made for clients must be predominantly based on their risk profiles, financial goals and time horizons of each of the goals. Sound financial advice must help clients by making them understand the risks involved with each product in their portfolios. It must also educate them as to how each product within their portfolios fits into the process of helping them achieve their financial goals. Finally, if any of the clients' financial goals logically warrants a heavy allocation to one particular asset class, portfolio risk must be rationalised through product choices within that asset class. For example, planning for a retirement goal that is 30 years away requires a predominant allocation to riskier asset classes such as equity. In such a case, choosing relatively low risk products within the equity universe such as large cap stocks index funds and ETFs can reduce risk. The final facet of sound financial advice is helping create tax awareness among clients. Sound financial advice must make clients fully aware of the tax implications that come with each of the products in their portfolios. Care should be taken to see that products chosen for clients do not involve a significant tax outgo. At the same time, reducing tax payments must not become the sole area of focus, of the advice that is imparted.

By now, it should be clear that sound financial advice is not about making the area of investing the sole focus of the advice imparted. Nor is it about trying to align the other aspects of personal finance to a set of product choices that have already been made. Instead, sound financial advice comprises of these five facets namely goal setting and quantification, insurance needs analysis, risk profiling and asset allocation, choosing the right investment products and ensuring tax awareness about each product. And all of these five facets are clearly connected with each other. Goal setting and insurance analysis set the base for a financial plan. Risk profiling and asset allocation provide clients' financial plans and investment portfolios with a well balanced structure. Suitable product choices fill out the structure of clients' portfolios and facilitate the process of long term wealth creation. And finally, making clients aware of the tax implications of each product helps them retain the majority of the wealth that is created. Therefore, it is only when any financial advice that is imparted incorporates these five facets in the right manner that it can be called sound, holistic, five star financial advice.

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