Financial Planning — A simple flowchart for people in tech and others. Part 2.

Part 1 | <Part 2> | Part 3

Why do you need financial planning in the first place? If your current income is higher than your expenses then everything else is automatically taken care of right? And then of course we have “Credit Cards” and instant loans for some quick fixes.

Is Financial Planning Irrelevant or Redundant?

What we often forget is that life is constantly changing and so are our needs. Today, maybe as a young professional in your twenties with zero family responsibilities, your income exceeds your expenses, but this situation will not last forever. Additionally, the economy is shifting, inflation keeps rising, the job market booms and falls, and you are just a small player on a global playing field.

Hence, it is extremely important that you plan your finances well. Unfortunately, this is not something you can “buy off the internet”. This is an exercise that you will have to do on your own, but don’t worry, I have some pretty good tips and hacks to make your life easier.

So far, we’ve established the fundamentals of “financial planning”. (link to previous blog). You’ve figured out your net worth and are raring to move forward.

The next step is pivotal for your financial plan and this step is 100% subjective and will vary from person to person.

Step #3 — Financial Goals

Financial goals are targets you want to achieve in the future using your income and investing skills. These goals can be both short term and long term. They can be small or big. They can be related to future asset acquisition or leisure. The nature of your goals is completely up to you — whether you want to save for a trip to Europe or to buy a 3 BHK in Bengaluru — the choice is yours. There is no right or wrong in goal setting.

• Open your Asset Register.
• Create a new sheet, name it “My Financial Goals”.
• Start jotting down your goals along with the timeline

Let me help you get started by addressing some of the most basic goals everyone should have -

1. Retirement
2. Medical Emergencies

Now apart from this, depending on your personal situation, here are some other goals you may want to add -

1. Buying a home
2. Funding your children’s education
3. Buying a car
4. Travelling to your dream destination

Be as detailed as possible while making this list. Now write the timeline when each goal needs to be achieved. Goals that are due in less than three years are short term goals and the rest which are due after three years are long term goals. This short term v. long term classification will matter when we reach the stage of smart investing and shifting your finances around.

A key point that everyone should remember when writing down your financial goals is the “Monetary Value” assigned to them. Write the “Present Value” for these goals. For example, if your goal is educating your kid and the present value of this goal is Rs. 1 crore. Then even if the goal is due in 10 years, let this amount be Rs. 1 crore. Do not try to adjust it according to inflation and other economic variables.

Retirement planning is the most important goal in your list. Lets see how you calculate the amount you need for it. First, compute the monthly expenses (in present value) that you anticipate in your retirement. If your expense is one lakh rupees per month and your post retirement life expectancy is forty years, then you need a buffer of five crore rupees in present value for your retirement. There are a lot of retirement calculators online that you could use to do a more nuanced calculation if you prefer.

Look at the goals you have set and the amount of money you need for it. Compare it to your current net worth. The difference between the money you need to meet your goals and your current net worth is the money you need to earn to retire. Do a sanity check for yourself. Are your goals reasonable? Is it reasonable to believe that your future earnings are on track to help fill the gap between the required net worth and current net worth within reasonable time.

Let’s do a thought exercise. Say your current net worth is zero. The desired net worth to meet your goals is 5 crore rupees. Your annual savings are 10 lakh rupees. Ignoring inflation, it will take fifty years to meet your net worth goal. This may be impractical. If you find yourself with impractical target net worth, change your goals. Either drop some goals or change the target numbers for them.

Future can change. It’s possible that you can start saving 50 lakh rupees instead of 10 lakh in the near future. You can reset your goals when that happens. It is best to keep the goals within the reach of your current earning and revise them as your means improve.

Step #4 — Cash Flow

When you reach this step, you must have noticed that to move from Point A (Current Asset Distribution) to Point B (Desired Asset Distribution) you need to shift your investments or acquire new ones or let go of certain assets in order to achieve your financial goals.

There are two main methods of making this possible -

1. Cash Flow
2. Right Investing

First, we will elaborate on how Cash Flow can assist in achieving your Desired Asset Distribution.

• Open a new tab in your Financial Planning spreadsheet.
• Name it “Cash Flow”.
• Write every inflow (post tax) you have over the next 12 months. (Salary, inheritance, rental income, agricultural income etc)
• Similarly, write every outflow you have over the next 12 months (EMIs, house expenses, insurance premiums, rent, car maintenance etc)
• Finally, when you subtract the outflow from the inflow, you will arrive at your Net Annual Cash Flow.
• For example if your Total Inflow was Rs. 10 lacs and Total Outflow was Rs. 7 lacs, then your Annual Cash Flow is Rs. 3 lacs.
• Your Net Annual Cash Flow can help you in understanding how many years it might take to reach your financial goals. So if your goal is Rs. 1 Crore and your Cash Flow is Rs. 3 lacs then it will take you (100,00,000/3,00,000) approximately 33.33 years to achieve your goal without any financial planning or investing.
• This is a simplistic checkpoint that will empower you to make better investment decisions. This is not a sophisticated formula that factors in inflation, salary hikes, asset appreciation etc)

Obviously at this point, you are wondering how to achieve your goals in lesser duration. No one will have 33 years to wait around for conquering their financial goals.

When this realisation dawns, you will have two more epiphanies -

1. In order to achieve your financial goals your cash flow needs to change or
2. Your financial goals need to be adjusted.

This step is actually a “Reality Check” for you. It will let you reevaluate both your goals as well as your outflow pattern. This is a vital step and ensure that you don’t skip it. This will help ensure that your goals are realistic.

Step #5 — Determine Desired Asset Distribution

The Current Asset Distribution you possess might not have the potential to help you in achieving your financial goals. Hence, you need to slowly move towards a Desired Asset Distribution which is in line with your goals.

In this section, I will share a very simple algorithm to come up with a desired asset distribution given your goals. In this section, we will not look at the specific investment channels you can use — the focus will be in determining the distribution across major asset classes like cash, liquid funds, gold, real estate, debt and equity.

Let’s take an example to simplify the concept.

• You have ₹ 1 crore.
• Begin by identifying goals that are due within the next six months. Suppose you have a goal that requires ₹ 10,00,000. Then keep this amount aside in Cash Funds.
• Identify goals that are due for completion in the next 3 years. Suppose they amount to ₹ 15,00,000. Now keep this amount in liquid funds so that you may easily convert it to cash when the goal’s due date approaches.
• For the goals that need to be achieved within 5 years, put aside the requisite amount in Debt Funds. In our example, let’s say the amount is ₹ 20,00,000.
• Calculate your monthly expenditure and then multiply it by 6. So you now have a cumulative expenses figure for the next 6 months. Keep this in Cash as well. For our example, let’s say this figure is ₹ 500,000.
• The balance that remains are now funds that are ripe for long term investments. In this case ₹ 50,00,000.
• Divide this amount as follows -
• 10% as Liquid Funds = ₹ 5,00,000
• Debt Funds = Percentage of (your Age — 10). In our example, let’s assume the age is 30. Thus, Debt Funds = 20% of 50,00,000 = ₹ 10,00,000
• Invest in Real Estate and Equity with the formula = Percentage of 100 — Your Age (100–30) = 70% of ₹ 50,00,000 = ₹ 35,00,000

You might have noted that the amount I am recommending to save in cash + liquid asset classes is much larger than the typical advice on most financial forums. Most forums advice just keeping about 6 months of spending as an emergency buffer in cash. I personally feel that a larger amount in cash can be very powerful, especially in a market like India where sudden fluctuations create great investment opportunities. Having cash at hand when that happens can be very beneficial. I also feel that this comes in handy when there is a sudden personal need that we had not anticipated.

The division between real estate and equity can be a personal choice. Both instruments can be difficult to liquidate. Equity usually has more short term fluctuations. Real estate usually requires a lot of time and effort to manage and even more to sell as it is a big ticket item. On average, in the long term, both equity and real estate are tracking the potential of the market but the two generally don’t track each other perfectly. In some pockets, real estate value lags the market value. In other scenarios, real estate value already bakes in the future potential. It is safe to assume that we will not be able to predict which is which. I personally do not invest in real estate just because of the hassles it comes with in terms of maintenance.

What’s Next

The next part of our blog series is the final and concluding piece. This will include how to move from Current Asset Distribution to Desired Asset Distribution through Right Investing. I am going to share guidelines on how to Invest, where to broadly invest and how to divest as you move closer to your financial goal timelines.

All of these steps will round off our Financial Freedom series.