Importance of financial planning
Financial planning is the process of defining different financial goals, quantifying these goals factoring in inflation and having an investment plan to meet these goals. Financial planning also prepares you for unexpected risks e.g. untimely death, serious illnesses, sudden loss of employment etc. The importance of financial planning helps investors achieve their financial goals e.g. home purchase, children’s higher education, children’s marriage, retirement planning, estate planning etc. and long term financial security.
Elements of financial plan
To explain the importance of financial planning, we will discuss the seven steps involved in financial planning. We will describe in brief what these steps are: -
Defining and setting goals: This involves defining your financial goals, timelines by which you want to achieve these goals and quantifying the goals factoring in inflation.
Expense budgeting: You need to save money to invest for your financial goals. Expense budgeting determines how much you can spend, which expenses you can reduce in order to save more.
Assessing your risk appetite: In this step, your financial advisor will assess your risk appetite based on your age, income, expenses and financial liabilities (e.g. loans). Your advisor may also assess your risk tolerance, which is personality based and how you react to adverse events.
Asset allocation: This refers to the mix of different asset classes e.g. equity, fixed income, gold etc. in your investment portfolio. Asset allocation is essential for risk diversification and achieving your financial goals. Your asset allocation will depend on your goals and risk appetite.
Investment plan: Investment plan is essentially knowing how much to invest and where to invest. Systematic Investment Plans (SIPs) are usually recommended for your long-term financial goals. Your investment plan may have a mix of equity, debt and hybrid funds depending on your asset allocation requirements.
Risk protection plan: An unfortunate death, critical illness or serious accident can cause financial distress to your family. Risk protection is an important element of your financial plan. You need to have adequate amount of life and health insurance cover.
Monitoring and tracking: You need to track progress of your financial plan towards different goals and take actions if required. Over a period of time, your goals may also change and you may have to make changes to your financial plan accordingly.
Why financial planning is important?
Many investors do not understand the significance of financial planning and think that if they are able to save money, they will have financial security. But saving is not enough. Let us assume average life span of 75 – 80 years. Your needs for the first 20 – 25 years of your life are taken care of by your parents. Your working life will typically be about 35 years long during which you will have to take care of the needs of your family (e.g. spouse, children, dependent parents etc.) and also save enough, to take care of your needs during the 15 to 20 years of your retired lives.
Inflation reduces the purchasing power of money in the long term and therefore, your money needs to grow at a faster rate than inflation if you want to achieve your financial goals. Certain expenses like education, medical etc. are inflating at a much faster rate than CPI inflation. You need to plan for it. Also, with rising incomes lifestyle changes, which means more expenses. It is not easy to change your lifestyle once you get habituated to it. You need that much more savings, if you want to achieve financial independence and also maintain your lifestyle. Given these challenges, you should know the importance of financial planning and know how much to save and invest, know where to invest and most importantly, start saving and investing from an early stage of your working life, in order to meet all your aspirations.
Benefits of financial planning
Save and invest more for your goals: Investors who are able to save and invest more will be able to create more wealth. Saving and investing according to a financial plan instils a greater sense of purpose in your journey for financial well- being and financial independence in the long term. The most important aspect of a good financial plan is goal linkage with investments. We have emotions attached with goals like buying your own home, children’s higher education, children’s marriage, leaving a estate for your loved ones etc. The emotional attachment makes your more committed to your financial plan. This is the significance of financial planning.
Disciplined investing: Discipline in investing e.g. sticking to your SIP irrespective of market conditions, adhering to your asset allocation, regular re-balancing etc., are essential in achieving success. You are likely to be more disciplined if you are investing according to a plan.
Helps you reduce debt / be debt free: Cost of debt can be a huge burden on your savings and harm your long-term financial interests. If you invest according to a financial plan, you can fund big ticket spending e.g. vacation, buying / upgrading your vehicle, bigger down payment for home purchase etc. from your investments and reduce your debt burden.
Better risk diversification: Asset allocation and risk diversification is a critical component of a financial plan. If you do not have a financial plan, you may invest in assets that give higher returns in bull markets and this may increase the risk in your portfolio. One of the benefits of financial planning is to protect your financial goals from the vagaries of capital markets.
Improve lifestyle in a sustainable way: Despite rising disposable incomes, average household debt in India is rising. This shows that investors are funding their lifestyles through credit cards, personal loans etc. Debt funded lifestyle improvements may not be sustainable. Sometimes it is seen that, parents spend a bulk of their savings on their children’s higher education and then compromise on lifestyle to save for their retirement. If you practise goal based investing, you can improve your lifestyle in sustainable way, without relying on debt or compromising on other financial goals.
Save taxes: Having an Insurance, savings and investment plan can help you save taxes under various and also invest in the most tax efficient investment options according to your financial goals and asset allocation.
In this article, we discussed the importance of financial planning. You may not have clarity on your life-stage goals in the early part of your working life. An experienced financial planner or financial advisor can explain why financial planning is important and also explain the importance of financial planning. A financial plan on paper or spreadsheet is of no use, unless you start acting on it. The earlier you start executing your financial plan, higher is your chance of succeeding in your financial goals. So start saving and investing.
Source:- mirae Asset