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The building blocks of financial planning: 1

By Sheetal Jhaveri
Last updated on: July 17, 2009 14:41 IST
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Arise, Awake and stop not until your goals are achieved: so aptly put forth by Swami Vivekananda. And that is what financial planning is all about!

It is about planning your money to achieve your goals within a given timeframe. Why do people toil away from morning till evening? So that they can achieve their goals! Goals can be different for different people at different times. For some it can be striving to provide for the basic necessities of life. For others it can be buying a luxury car or going for a world tour. And you can't achieve these goals without financial planning.

The only problem is that many individuals tend to confuse financial planning with investment planning. Once they know which fund or script or investment avenue to deposit their money into, they are relieved and consider their financial planning as over. This indeed is a very big blunder.

What about insurance? Are you adequately covered or is your health insurance enough or what about retirement or emergency funds?
 
How we wish financial planning was that simple by doing a few simple investments your goals would be met. But the path towards our goal is never that easy.  There are steps to follow and blocks to build before achieving your goals.

Investment planning is just one part of the entire financial planning exercise. Just like a building where a strong foundation is led first and then the next levels financial planning too has to have a strong foundation.

Let us have a look at the building blocks of financial planning wherein we will learn to build each block one by one. We will start with the foundation and then gradually move upward from the foundation to the next level to build a strong financial plan. So you are financially prepared for all events in life; be it any medical emergency or your child's education or marriage or your own retirement or health problems.

The building blocks of financial planning

Just like a building where you start with the foundation and then move upwards towards the first floor, second floor and so on, the financial planning building has five blocks to scale. The first two blocks are the foundations and then the next three levels where you actually experience the benefits of a strong foundation.

Let us have a look at these blocks, what they are and how to go about their planning:

5. Estate planning (Will planning)
4. Retirement planning
3. Investment planning
2. Insurance planning
1. Contingency planning

You might be wondering why the reverse order? Just as I mentioned we have to build the foundation and then move upwards. The foundation starts with contingency planning and then you gradually move up.

The first two blocks: contingency planning and insurance planning is known as risk management. Also in a layman's term, it is the foundation of a good financial planning. Once this is in place, you are not worried as it takes care of all your emergency situations (contingency planning) as well as your insurance requirements (that is your health insurance, life insurance and other insurance).

Once your risk is managed, you can then safely move on to the higher levels to plan for your goals. The next two levels are investment planning and retirement planning collectively known as goal planning.  The last but not the least is estate planning or will planning.

Let us start with the foundation and the first of the two levels in risk management.

Contingency planning

Also known as emergency planning. It has been emphasised time and again that a contingency plan or an emergency plan has to be in place before starting to plan for other goals. Why? Emergencies can come anytime or anyplace especially when we least expect it. We cannot predict it or even prevent it but what we can do is buffer ourselves against it so that our life does not go for a toss due to the emergency. It is basically saving for a rainy day. So once that you have planned for any untoward or unpredicted eventualities, you can safely move ahead to the next level of the financial plan.

How to calculate?

All your mandatory monthly expenses which you have to meet by hook or by crook have to be taken into account. A list of all mandatory expenses have been given below:

Fixed mandatory expenses (which are fixed every month) include:

  • Mortgage installment
  • Car loan installment
  • Other loan installments
  • Life insurance premium
  • Health insurance premium

And variable mandatory expenses (which are mandatory but vary every month) include:

  • Food
  • Utilities
  • Grocery
  • Transportation
  • Miscellaneous (unavoidable) expenses

The above expenses have to be calculated on a yearly basis and then divided by 12 months so as to arrive at an average monthly figure.

How much to set aside?

At least three months of your average monthly expenses have to be kept aside in the form of emergency funds since it is generally observed that three months worth of funds are enough to meet most emergencies and come back on track. People nearing retirement should try and keep aside at least five to six months of mandatory monthly expenses as contingency fund.

Let us take an example: Say your yearly mandatory expense is Rs 350,000.00. Hence your monthly average expenses will come to Rs 29,167 (3,50,000/12) (rounded off). You need to keep aside Rs 87,500 (29,167*3) that is your three months' average monthly expenses as contingency funds to meet any eventualities.

It is not necessary to keep the entire amount in cash. You can keep aside Rs 20,000 in cash and the balance you can split between savings account, fixed deposit, or liquid funds. Why? Because all of the above mentioned products have liquidity, their biggest advantage, which is a very important feature in case of any emergencies. Also, remember that in case of usage of these funds always remember to replenish it. 

Now that we have covered the first level of a financial plan, we can boldly move towards the second level that is insurance planning which will be dealt with in the next article... Till then think how best you can build your first block -- a strong foundation -- on your journey towards a strong financial plan.

The writer is a certified financial planner and can be reached at dhanplanner@rediffmail.com.

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Sheetal Jhaveri
Related News: Swami Vivekananda, Health
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