Financial planning
Subsequent to my last blog post, I had a couple of friends asking me as to what an ideal financial plan looked like. Well, there is no ideal financial plan! There are plans that talk of what’s best for a typical investor. But you are not a typical investor, you are you! So, at the best you could have a few thumb rules, but there is no substitute for working with your financial planner in developing a plan that works for you. In this blog, I discuss some of the thumb rules.
Taking stock
Before you start off on putting together the plan you need to know what your financial position is. You need to have a handle on your assets, liabilities, income and expenses. This is no rocket science. Just make a list of the things of value you own, things like your house, stocks and bonds, MF investments, bank deposits, PF balance, etc. Similarly list out all the loans you may have taken. Then look at your income, include salary income and regular income from all other sources. Finally, look at your expenses. Make a distinction between your discretionary and non-discretionary expenses. The former are expenses that you should be willing to forego to hasten your journey towards financial freedom. This could, for instance, mean cutting down on the number of restaurant visits, watching that latest movie at home rather than at the multiplex, etc. Please be easy on yourselves as you do this. Cutting out all the spend on recreation – for instance- may make the journey towards financial freedom appear as not being worth the trouble.
Asset allocation
Now that you know where you stand financially, you need to set your financial goals and allocate investments to achieve those goals. Asset allocation plays an important part here. It is often tempting to go after the latest buzz and invest in an asset class that has performed the best recently, like equities and real estate in
The basic idea behind diversification is that different asset classes react differently to economic events. For instance, when an economy is contracting, corporate profits fall. Demand for office space falls too. This is bad news for stocks and real estate. Demand for money comes down and interest rates fall, pushing up the bond prices, which is good news for those investing in debt. Similarly, when an economy is in the upswing, the reverse could happen, when stocks and real estate outperform debt. Thus, there are times when one asset class does better than the rest. As almost no one can time the entry into and exit from asset classes successfully, it may make sense to diversify across asset classes.
The asset classes
The asset classes that an individual investor most commonly looks at are stocks, real estate, gold
and debt – including cash. Please note that I don’t include insurance here as I don’t look upon insurance as an investment. Insurance is protection against unforeseen events. So, include the cost of insurance in your expenses. Don’t look upon that as an asset.
There is no magic allocation formula – that says x% should go into equities, y% into debt and so on. Be extremely wary if your financial planner uses a pre-built model to calculate the asset allocation for you. It makes no sense and it amazes me that almost all financial planners take this route. I am making this statement based on my personal experience.
Once you have decided on the asset allocation, you need to make reasonable assumptions about the kind of returns you should expect from each one of the asset classes you would have decided to invest in. As Mark Twain remarked, “History does not repeat itself, but it does rhyme”. So, past returns over a reasonable long period of time – say over the past decade- should be a good indicator of the returns you should expect.
With your asset allocation decided and return expectations built in, you are on track to know how close you are to achieving financial freedom. I have designed a spreadsheet that lets you determine this. Please send a mail to investingforfinancialfreedom@gmail.com and I will happy to revert with the same.
I will discuss the rationale for investing in each one of these asset classes in subsequent posts. Till then!
Disclaimer
Please note that the information contained and provided in this blog is of a general nature and it is not my intention to provide any professional advice, solicitation or offer to sell, recommend or purchase securities and/or funds to the readers of this blog.
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