Our financial plans are indicative of our desires, dreams and every other thing that we want our money to achieve for us. In effect, this means that our financial plans should ideally be constructed in a way that is highly personal, specific and contextual given each of our needs. But even so, the basic structure of any well conceptualised financial plan remains largely similar. And this is true regardless of the individual for whom the plan is created. That means anyone can use the basic structure of a financial plan to create one for themselves. Therefore in today’s blog post I am going to throw light on this universal structure for financial plans and show how each one of us can incorporate it into our financial plans. I will be breaking the overall structure down into it's individual components and showing how each component of the structure can be built.
Any well structured financial plan would follow a bottom up approach. And it would have the following components flowing from bottom to top :
° Cashflow management
° Life, health insurance
° Emergency funds
° Investment portfolios
° Tax awareness
So basically, cashflow management would be at the very bottom of the structure of a financial plan. This goes to show that cashflow management is the most important fundamental component of the structure of any holistically created financial plan. All the other components of the plan would be built around the cashflow management system with tax awareness being the final component coming at the very top. This can be understood better looking at the diagrammatic structure given below.
Building any effective financial plan begins with putting an effective cashflow management system in place. Doing this would create a system for our money to circulate effectively between various aspects of our money management while clearly showing how each unit of money is coming in and being employed. Preparing an unbiased budget and having separate savings accounts for expenses, emergencies and splurging would be the most effective way to set up a cashflow management system. We must ensure that the money in each account should only be used for the originally intended purpose. Putting such a system in place may require a few months initially, but would be worth the effort in the long run.
The next component is that of taking care of our life insurance and health insurance needs. Though the amounts of insurance each one of us requires may differ, as a thumb rule our lives need to be ensured to the tune of 20 times our annual take home household income at the very least. Term insurance is the only viable product choice for our life insurance needs. Buying the policy online would be preferable since premium payments would be slightly lower. The amount of health insurance we require would depend upon the locality where we live. Those of us living in big metropolitan cities require more health cover than those living in smaller towns. In the Indian context those living in major cities would require a minimum health cover of Rs 10-15 lakh. Those in smaller towns and villages would need a minimum health cover of Rs 5-10 lakh. It is best to buy a family floater policy online so that the health cover extends to each member in the family at reasonable premiums. Also given the current COVID situation, policies which provide coverage for COVID treatment would be preferable.
Once our insurance needs are taken care of, it would be time to go about creating an emergency fund for ourselves. An adequately sized emergency fund would at least have as much as one year's expenses parked in it. In order to effectively create an emergency fund, we must first clearly define what constitutes an emergency for us. Basically, an emergency is a financial nightmare that catches us unawares. The financial realities each one of face are different. So naturally, each of our financial nightmares would be different and hence should be defined clearly. The money parked earmarked as an emergency fund should not be touched for any reason other than meeting our predefined emergencies. Therefore, emergency funds are strictly not meant for generating returns. The ideal avenue for an emergency fund would be one that involves no risk whatsoever, is easily convertible to cash and does not change in value at the time of conversion. Therefore options such as liquid cash, high yield savings accounts and fixed deposits would be ideal to create an emergency fund. A special purpose credit card with a balance of a few lakhs may also be used.
Getting these aspects right would set a solid foundation for our financial plans. With the base set, we can move on to building our investment portfolios. As usual, zeroing in on an asset allocation strategy is the foremost step when creating a portfolio. Most people are of the opinion that young earners in their 20s can who are new to the markets can have an equity allocation of 80% or more owing to their age. But in fact, new investors may be better off if they begin by building portfolios to a low risk construct. So a 60-30-10 split between equity, debt and gold will do just fine for a start. Exposure to equity can be increased gradually in later years. Initial product choices within each asset class can be made by choosing relatively low risk products within each asset class. Some examples include large cap stocks, large cap index funds and ETFs, EPF/NPS, PPF, gold ETFs and so on. Riskier products such as mid cap stocks, large cap stocks, mid and small cap ETFs, debt mutual funds and so on may be added gradually in later years as required. The advantage of including riskier products in our portfolios in a phased manner over a few years is that we can recognise the level of risk we are comfortable with and maintain that level of risk. Also we must reduce equity exposure by at least 10% with each passing decade in our lives. This would ensure that we have minimal exposure to equity by the time we retire.
The final component of a well structured financial plan is complete awareness of the various tax implications that come with our investment products. Being aware of the tax implications of our investment products allows us to protect the chunk of our wealth and investment gains that would otherwise have been eaten away by taxes. Therefore, we must take advantage of any tax benefits that come with our products. But, tax benefits are just one aspect of our investment products. We must hence ensure that we don't obsess over tax benefits and overlook other vital aspects of our products such as their risk profiles and how they fit into our financial plans.
By now it must be clear that though the product choices and specifics of each of our financial plans may differ, the basic structure of any well conceptualised financial plan would be broadly similar and carry pervasive utility. This means that the basic structure of a financial plan can be used by anyone to create their financial plans. All that we would need to do is to properly understand each of the individual components of the overall structure, the sequencing of the components in the overall structure and build our financial plans accordingly.