The Importance of Financial Planning

financial planning Apr 22, 2021

We all do, and should, have financial as well as aspirational goals. And, to achieve these goals, our forefathers (broadly) taught us to earn and save. We can spend our entire life working to save money. But, if we do not plan and invest this money, all our efforts go in vain. Financial goals are such as education, marriage and retirement etc. while aspirational goals could be buying a dream house, travel around the world, own a piece of art or set up a philanthropy fund.

Let me explain in layman’s language. The money in the bank is safe only if the bank is safe. And it is this factual caveat that has prompted governments around the world to set up deposit insurance mechanisms to protect the fixed sum of your principal amount against a bank default. Not only the rest of your corpus remains exposed without any insurance but there is almost zero real growth on your aggregate deposit. The reason being the interest rates are generally tied to the inflation rate of the country in which your deposit is domiciled. Therefore, one has to step out of one’s comfort zone to invest in financial assets be it real estate, gold, equities, bonds etc. with an aim to achieve positive real rate of return (return net of inflation).

What is inflation?

Remember the time you went to a multiplex with your family. You must have probably heard your grandparents say: ‘Everything was so cheap back then’. It’s true. See the graph below. Similarly, chocolates, clothes, coffee, petrol and other regular goods were much cheaper ‘back then’. This phenomenon of prices rising over the years is known as inflation. It is the steady increase in the price of goods and services over time. And if you are not careful, it can eat into your savings in no time. 

 

Here’s a simple example to illustrate its effect.

Imagine a carton of milk costs $10 today and you have $100. With this amount, you can buy 10 milk cartons. Over the next one year, imagine you keep $100 in a bank that offers you an annual interest rate of 5%. At the end of the year, you have $105 with you. Assuming the price of the milk carton over the same period increases to $110. This means you have to pay $110 to purchase the same 10 milk cartons next year. But since you have only $105, you fall short of $5. This is how inflation eats into your savings. It reduces purchasing power over time, and you have to spend more money to buy the same goods.

You can combat inflation by investing in avenues that offer you better returns over time. But for this, financial planning is critical.

Let us understand what financial planning is and why it is so important.

“A financial plan is a comprehensive step-by-step tailor-made approach to meet one’s life goals. A financial plan drawn in accordance with your financial goals taking into account your current financial position acts as a guide that helps you achieve your short and long-term financial objectives in the most effective manner. Basically, it helps you to be in control of your income, expenses and investments”

Among many practical benefits of financial planning, it helps you to:

Improve your savings:

Regardless of the amount of income earned, part of the earnings will go for tax payment, expenditure and what's left would be the savings. An analysis of available cash versus the tax liability and monthly expenditure will help you manage your income better and increase the cash flow.

Create a contingency fund:

Creating an emergency fund is a critical aspect of financial planning. As a rule of thumb, you need to ensure that you have a fund that is equal to at least 6 months of your monthly income. This fund can come in handy in case of a family emergency or a job loss. The emergency fund can help you face unexpected expenses on time. The COVID impact worldwide is one such example of contingencies.

Identify investment opportunities:

Right asset allocation and suitable investment programs are key to having greater effect on investment success. Properly evaluated investment opportunities born out of a good financial planning have the potential of turning goals from dreams into realities.

Attain financial understanding:

With a whole new approach to budgeting and investing, one can evaluate the risk factors in an investment portfolio or adjust a retirement plan to meet the sudden changes in the family circumstance, for instance. It is, therefore, obvious that when measurable financial goals are set, the effect of each financial decision is understood, the financial situation is periodically evaluated, financial planning is implemented with realistic expectations, and ultimately one is fully in control of one’s finances, a certain degree of financial understanding is attained.   

Have a better standard of life:

It is a common misconception that one would have to sacrifice one’s standard of living to pay monthly bills and EMI repayments. On the contrary, with a good financial plan, you would not need to compromise your lifestyle. It is possible to achieve your goals while living in relative comfort.

Achieve peace of mind:

Availability of adequate funds to cover your monthly expenses, invest for your future goals and splurge a little for yourself and your family, without worry, can be a blessing in today’s stressful life. Proper planning e.g. insurance for family, and disciplined investments can help you build the financial future. Financial planning helps you manage your money efficiently and enjoy peace of mind.

Financial planning for life goals

  1.                   Wealth creation

As mentioned at the onset of this article, the rise in the price of everyday items means that if you want to maintain or increase your current standard of living in the future, you need to create a sufficient corpus of wealth. You may also want to purchase a better car or start a new business in the future. All this requires money, and it merely highlights the importance of wealth creation. It is possible to achieve these goals by carefully investing your money in the right avenues. Equity mutual funds can be a suitable option for long term goals. These funds could help the investor to accumulate wealth in the long run.

 

  1.                   Child’s education

Education across the world has become very costly, and in future, this cost is only going to rise. This is why it is imperative to start planning from the moment your child is born. Depending upon your preliminary targeted education institute’s,, calculate how much you wish to earn and start investing in long-term investment avenues that can help you achieve this goal.

 

  1.                   Tax saving

The old adage “there are only two things that are certain – death and taxes” is very much alive. While you are probably paying a substantial amount as tax every year, you can lower your tax liability legally. By planning your taxes in advance, you can identify the best avenues to invest your money in either tax-sheltered or tax-exempt products, and reduce your taxable income.

 

  1.                   Retirement planning

It is best to start planning your retirement at the earliest even if it is 25 or 30 years in the future as it helps secure your future against financial uncertainties. To enjoy a happy and comfortable (especially financially) retired life, you need to start building your safety net right now. Besides, your outlay would be lesser if you start early and gain from the power of compounding, which helps to build a large enough corpus over the 25-30 year period.

Conclusion

The fact that everyone needs to be financially independent and secure right up to the sunset days of his/her life, comes with its twin that a financial planning is critical for financial freedom. Benjamim Franklin has rightly said, “If you fail to plan, you are planning to fail.”


- Ramesh Sadhwani


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