How to Make a Personal Financial Plan – Basic Considerations

Introduction

Sound financial planning and prudent money management are the foundations on which you can build the castle of financial freedom. Our finances, if not managed well, can be a source of worry. Hence, there is a need to understand this subject well. 

Unfortunately, formal education (school, college, university) doesn’t cover this subject very well. That is why even some of the top university graduates are found struggling during their working life when it comes to managing their hard-earned money.

The purpose here is to suggest ways and means to optimally leverage your financial resources and reach a stage in life – earlier the better – where it is no more necessary to work for money. You may continue working but for higher motives e.g. your passion, need to address an existing human problem, philanthropy, or leaving a legacy behind. The quality of your work will improve considerably when you are free of financial worries.

The ideas discussed here are widely applicable, however, are particularly useful for middle-class people where the money supply is limited but financial goals are compelling. 

So, please leaf through and try to glean something useful.

Make a Financial Plan

Making a workable plan according to your needs and aspirations is very important. Some essential inputs into your plan could be your approximate monthly and annual earnings, at what stage you are in your career and your risk profile which should include your age, health condition, number of dependents, etc. 

• Make a shortlist of your financial goals, both short and long-term. 
• Make a plan to achieve your goals. 
• The plan should be simple and realistic. In financial matters, simplicity is very powerful. Have fewer products in your portfolio. Don’t go after what is trending in the investment space. Being safe and conservative is better than betting on something which you don’t understand well enough but is otherwise quite popular.
• Two very important ingredients of your plan are:
  • Regular income stream (monthly, yearly) to fulfill your recurring needs e.g. kitchen, utility bills, clothing, education, healthcare, etc.
  • Wealth creation with the ultimate aim of becoming financially independent. Remember! The best thing you can buy with money is financial freedom. If this is the goal, the path is wealth creation through making well-considered investments. There is no other way.
  • Maintain a balance between these two aspects and never let them mix up. To be safer, create a buffer in between by maintaining an emergency cash reserve roughly equal to 6-8 months’ expenditure. 
• You may tweak your plan periodically or when the situation changes significantly.

Have a System in Place in the Shape of a Checklist

A fairly popular belief is that as long as the result is positive, just go with the flow. There is no need to have a system of thinking in place. If something is giving positive results and a vast majority of people believe it to be good, it must be so. This way of thinking can prove to be financially very dangerous and can result in permanent loss of capital.

Hence, there is a dire need to have a pre-meditated process in place that should help you think rationally.

It can be useful in the following ways:

• Whenever a sales pitch is thrown at you e.g. some insurance company representative wants you to buy insurance from him, you will exactly know how to deal with it as you would have a pre-defined response.
• This will help you stick with your plan because you will easily know whether a particular buying or selling decision is taking you closer to or away from your financial goals.
• Financial products e.g. a loan, shares of a company, or an insurance policy, unlike physical products e.g. a TV, an automobile, etc, have an intricate feedback loop. Sometimes, till long after you buy them, it is difficult to carry out a cost-benefit analysis. Hence, most of the thinking has to be done before buying them.

The system of thinking we are discussing here can be a set of some DOs and DON’Ts. It can be on the following lines:

• I will always take a long-term financial view.
• I will never get a consumer loan.
• I will clear my bills, including credit card(s), on time.
• I will not receive marketing calls.
• I will not invest in unregulated sectors. (In the developing world, many sectors of the economy have yet to be regulated). 
• I will never speculate.
• I will not invest in gold or forex. 
• I will not buy a financial product that I don’t fully understand.

These are only a few examples. You may have your own set of such injunctions. These are very helpful. Without them, it becomes difficult to follow your financial plan.

For a detailed checklist, please click here.

Invest, Don’t Speculate

Making a clear distinction between investing and speculating, as part of your personal finance checklist, can be extremely useful.

Arguably, the best definition of investing has been provided by Benjamin Graham in his book: The Intelligent Investor:

“An investment operation is one which, upon thorough analysis, promises safety of the principal and a satisfactory return. Operations not meeting these requirements are speculative”.

​In the marketplace, speculative financial products are often presented as investment opportunities. It takes a fair bit of know-how to make a distinction between the two.

I intend to write on this subject in detail later, but here I am providing a few tips only:

• Refrain from financial products which have a price only, without having any earning ability e.g. gold, forex, commodities, cryptocurrencies, and so on. You may like to buy them but then you should know that you are speculating – not investing – and expect the results accordingly.
• Consider those entities seriously which, in addition to a price, also have a regular (monthly, yearly) income e.g. shares of a business, rental real estate, etc. However, this should not be the only reason to buy them. There are other factors to be considered.
• While thinking about investments, be very skeptical and critical. Don’t give benefit of doubt. It is better to think in terms of what can go wrong instead of what can go right.
• Investment has to be on a long-term basis. Investment targets value and value creation takes time. There are no quick bucks to be made.

Investment Avenues

Here I will give a gist of what all money can buy in the name of investment. I will also indicate the peculiarities of each and what should be a fair expectation.

Real Estate

Rental

• Residential (House or Flat).   A safe investment. Capital gain can easily beat inflation. An annual return of 3-5% should be expected.
• Commercial (Shop or Office).    4-7% annual return is a fair expectation. Rest is same as residential.
• Agricultural Land.    3-7% annual return should be expected. A very safe investment.
• Annual returns given here are rough estimates. May vary significantly depending on a host of factors.

A Plot

A plot, whether residential or commercial, purchased with the intention to sell it when the price rises is a speculative undertaking and doesn’t fall in the investment category. Therefore, nothing can be said about the expected return. 

Equity

Share in a Business

There are two types of equity: private and public. When you start a business with a partner or invest directly in a running business or a private company, it is called private equity. When you buy shares of a public listed company either from an initial public offering (IPO) or from the stock market, it is called public equity.

Thorough research is required before taking a buying decision. Although average annual expected returns may drastically vary due to various factors, 15% would be a fair expectation. It can easily take care of inflation. There is a wide variety of businesses you can invest in.

If you buy the same businesses trying to take benefit of the price fluctuations while disregarding how the underlying business is performing or is likely to perform, it is called trading which is entirely speculative and the returns cannot be assessed.    

Mutual Funds

If you don’t want to or cannot buy shares directly from the market, you can do the same through mutual funds. Investing through mutual funds is slightly different from buying directly from the stock market which will be discussed, in detail, in a separate article.

Debt

If you buy instruments where the income is fixed and you will get your funds back on expiry of the tenure, you are said to have invested in debt. Bonds and fixed-income funds are examples of such investments. These are very safe but low-return options. Investments in debt depreciate at the rate of inflation. Whereas, equities have an inbuilt mechanism to auto-adjust for inflation.

Others

• ​Gold.   Speculative. Prices are determined internationally. Likely to become pricier in uncertain times as states, financial institutions, and individuals use it as a hedge. Over a long time, it is slightly better than debt.  
• Cryptocurrencies.   Speculative. Have appreciated manifold in the last few years. Nothing can be said about their future with certainty. A lot depends on how the international monetary system and powerful states react, as these currencies defy any state control. 
• Forex and Commodities.   Speculative. Difficult to comment on the expected return.
• Cash.   It depreciates with inflation. Should be kept in limited quantity to fulfill short-term needs.

6 Money Related Actions and Their Interplay

You are doing one of these things with money all the time: earning, saving, spending, wasting, investing, or speculating. Being slightly conscious can really help:

Earning

Make a consistent effort to increase your earnings. It is better to have multiple sources.

Saving   

If your earnings increase, so should your savings. If you don’t do it, you will never have enough money to invest, which should be the primary purpose of saving money. 

Spending

Do need-based spending. Plan it well. It can be easily confused with wasting money.

Wasting    

Be careful. Avoid wasting money because it is going to eat up your savings and you will not be able to achieve the goal of financial freedom through investing.

Investing

This is a very important aspect of money management. Learn to invest. It is tricky and doesn’t come naturally. Make a clear distinction between investing and speculating. In short, investing is well thought out. It aims at an adequate return on a long-term basis. Whereas, speculation is more like “toss of a coin” and is very risky. 

Speculating

Must be avoided, as already explained.

Protect the Principal – Never Lose It

If you want to grow your net worth, the most important guideline to follow is to protect the principal at all costs. According to Warren Buffet: a renowned investor, you must follow these two rules about money: rule number one is – never lose money – and rule number two is – never forget rule number one. 

In doing so, even if you have to settle for a relatively lower return, go for it. Be content with a predictable and steady return instead of eyeing a very high return because everyone is talking about it. 

What it implies is that if you have two options, as under:

Option one is, there is a 90% chance that you will get a 10% return in a given time frame. and

Option two is, there is a 10% chance that you will get a 90% return in the same period.

Which option will you opt for? Without a doubt, you should go for option one. It is going to benefit you more.

There is also a mathematical way of looking at it. If you lose 50% of your principal, you will need 100% gain just to break even. It underscores the need to jealously protect your invested capital. Doing so with the expectation of a meagre return is not a heavy cost to pay.

Debt is Tricky. Beware!

Happy is the man with no sickness, rich is the man with no debts – a Chinese proverb.

Debt should be viewed as a resource, however, a tricky one. There are two types: good debt and bad debt. The distinction should be understood well so that you can use it to your advantage.

Good Debt

It is available at softer conditions e.g. low markup and to be paid back over a longer period, etc. You want to use it to enhance productivity of your business which is already well established. Paying it back over the stipulated period along with its accruals will not be a problem. You are also keeping a safe margin for unforeseen situations.

Bad Debt

It is available at a high markup. The purpose is either to buy a product you can do without or you intend to start a new business. You have no clear plans of how to pay it back. Accumulated credit card bills and consumer loans are some examples.

Differentiate between good and bad debt. Use good debt to your advantage, if you must, and avoid bad debt, as far as possible.

Don’t Box Above Your Financial Weight

Try to accurately assess your financial weight. While you should always strive to enhance it, over-projecting it for social reasons can be counterproductive. Some useful tips are:

• ​Live well within your means. There is no harm in living frugally.
• Know your needs well and make them your first priority. Desires can be the second priority.
• Understand the difference between happiness and pleasure.
• Look for happiness in experiences rather than flashy articles and expensive gadgets.
• Don’t be sucked into the consumer frenzy. Instead of reacting to market signals, make well-thought-out buying decisions.

Retirement Planning

​Ideally, retirement planning should start at the beginning of your working life. The second best time is to start now. 

Your need for money is likely to outlive your ability to work. Therefore, till you are working, your present self should pay some part of your earnings to your future self. This will be in the form of savings which should gradually convert into investments.

By the time you retire from work, your investments should be ripe enough to give you a regular income considerably more than what you need. This should be able to take care of your recurring expenditures.

Some More…….

Some other considerations which can be very useful while making a personal financial plan are briefly discussed here:

Pay Yourself First

In The Richest Man in Babylon, where George S. Clason explains his “Five Laws of Gold”, the first thing he mentions is “pay yourself first”.

It means that whenever you start earning in life, you should set aside 10-20% of what you get paid. This saving can then be put to work through investments on a long-term basis to make you financially independent eventually.

​Make Your Money Work for You Instead of You Working for Money

Robert Kiyosaki explains this concept very well in his book: Rich Dad, Poor Dad.

During the early part of your life, you will have to work for money but slowly and gradually you can start putting your saved money to work. Generally, money works better for more money than people working for money.

Set the Compounding Engine in Motion

A statement attributed to Albert Einstein reads: Compounding is the 8th wonder of the world.

It is really a very powerful concept. You may like to embed it in your financial plan.

Look around for some compounding engines and set them in motion as early as possible.
The following example can give a hint of how wonderful it is:

1 crore will become 10 billion in 30 years. The compounded annual growth rate (CAGR) required to accomplish this exceptional feat is a mere 25.89%!

You may like to get hold of a CAGR Calculator and crunch some numbers.

Tax Planning

We owe some taxes to the state, hence tax planning is important for which a reliable tax expert should be hired. Alternatively, you may like to get conversant with the tax laws yourself.

Insurance

Some knowledge about insurance will always be useful. You may see it for yourself whether you need it or not e.g. life insurance is required only by someone who has dependents. Term insurance should be preferred over endowment plans and so on.

Conclusion

The need of having a well-thought-out and workable financial plan cannot be emphasized enough. It calls for rational thinking, long-term perspective, and emotional maturity to persist in the ups and downs of life. It should consist of realistic long-term and short-term goals, some DOs and DON’Ts, skillful use of available financial resources, and an ability to appropriately modify it, if and when the need arises. Ultimately, its purpose is to help you achieve your goals and have fun in life.

How did you find this content? Please comment. Also give suggestions, if you have any. Cheers!

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A Brief History of Money

Why I Started a Blog on Personal Finance

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Debt, Equity, and Real Estate: An Overview

Retirement Planning

How to Compare Equity and Real Estate as Investment Options

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