Financial Planning — A simple flowchart for people in tech and others. Part 3.
Final step: Investing
We finally come to the last and relatively the easiest part of financial planning — this step is investing. Most people confuse investing and financial planning to be the same thing. That is why, they skip all the steps we have covered so far and directly attempt to invest their money in different channels.
In the previous blog posts (part 1, part 2), we had calculated your net worth, set your financial goals, identified your income and using all of these, created a current and desired asset distribution. Now, we need to create an investment plan that will take us from the current asset distribution to the desired asset distribution over time. Rather than explain in theory, I will explain the steps using an example. You can change the specifics to your own numbers and follow along these steps.
Let’s say that your current distribution is as follows:
Cash — 20
Liquid — 0
Debt — 30
Equity — 0
Let’s say that your desired distribution is as follows:
Cash — 10
Liquid — 10
Debt — 10
Equity — 20
Let’s start with Equity. It needs to go from 0 to 20. Divide this by 12 to get the monthly SIP (Systematic investment plan) amount — in this case, it is 1.67. Cash needs to go from 20 to 10. Divide this by 12 to get the monthly SWP (Systematic withdrawal plan) amount for cash — in this case, it is 0.83. Do the same for other classes.
Here is what you get:
Cash: Monthly SWP of 0.83
Liquid: Monthly SIP of 0.83
Debt: Monthly SWP of 1.67
Equity: Monthly SIP of 1.67
Systematic Investment Plans
Why did I pick 12 months and divide all amounts by that number? This is because we want to average our fund transfers to average out the gains and losses over a reasonably long period of time. If the amounts you are investing are large as a function of your future earning potential and the percentage changes are large, even 12 months may be too less. For example, say you want to rebalance equity from 0 to 50% of your net worth or say you are rebalancing your portfolio that has been built over 20 years of savings, you may want to choose a period of 3 to 5 years for SIP and SWP to rebalance your portfolio to average out the risk even more.
Selecting Investment Channels
Once you know the SIP and SWP amounts for all classes, you are ready to choose the specific instruments to invest in.
Cash
Split your money across multiple banks to reduce the risk of losing money to online fraud. Most banks support online fixed deposits or savings accounts with auto FDs. Choose those.
Liquid
Through a brokerage or mutual fund account, just pick 2–3 well performing liquid funds. This will average out your risk in case one of these ends up performing poorly.
Debt
Maximise PPF and EPF investments. These are as safe as it gets. Returns are tax free. Moreover, the investments in these are free from all personal financial liabilities as these investments come under MWPA (Married Women Protections Act). This helps provide an additional safety net for your future. Beyond EPF and PPF, pick a basket of debt funds representing short, medium and long term bonds to hedge your overall risk.
Equity
Avoid investing in individual stocks as it’s as close to gambling as it gets, especially if you are a novice investor. Instead, invest in the entire market. Majority of individual stocks as well as managed funds fail to beat the market over a long period of time. This is a finding revealed by Daniel R. Solin in the book “The Smartest Investment Book You’ll Ever Read”. In India, we still don’t have good index funds. Our indices (Sensex and Nifty) comprise a very small number of large cap companies since those companies capture the majority of our overall market cap. However, that creates a risk for us as an investor as these don’t reflect emerging trends. Thus, you may need to create your own index. I typically invest in 2 funds of large cap, mid cap and small cap each with an investment distribution of 60%, 25% and 15%. This averages out the risk quite a bit and is a reasonable approximation of the market, both as it stands today and as it is expected to trend in the future.
Conclusion
Creating a financial plan is difficult. Not because the concepts are hard. It is difficult because most of us don’t think of investing in a systematic manner as required. We all have this as an item on our TODO list which keeps getting pushed down to make room for other things. I believe this is because many of us don’t feel confident in our ability to do the right thing and thus constantly fear making a mistake.
In fact, even if you gather up the courage to follow all the steps in this series and create a plan, you will find that actually taking steps to execute that plan will be super difficult. Instead of logic, emotions drive our actions. However, every year that you delay creating and executing on your financial plan, you are losing money.
If you did create and execute this plan, congratulations. You have taken the critical steps towards your financial future. What is more, once you have done this once, things become very easy thereafter. In most cases, you only need to revisit the plan and update the details once every year. Very rarely, in light of major personal or market shifts, you may need to do an ad hoc plan update in the middle of the year.
As you revise your plans year over year, keep in mind that you may have to adjust your asset distributions depending on how close your goals are approaching. Let’s look at this in more details.
Imagine we are in Year 1 and you have a goal that is coming up in Year 5. then the first two years, you can continue to invest in the way we have discussed above. Now, in Year 3 and 4 begin shifting Equity Assets equivalent to your goal value into Debt Assets. In Year 5, switch them completely to Cash and Cash equivalents. This is extremely important because when the goal comes due, you have liquidity on hand to meet it and you will not be stuck due to some unforeseen market turn.
Final Thoughts
My “Chasing Financial Freedom” series is an attempt at simplifying the complex and multi-layered world of finance and economics for the layperson. I believe that the knowledge of managing your money and planning for a secure financial future should be a fundamental topic of understanding for every individual. This knowledge should be free flowing and accessible to all. Through my blogs, I have tried to give you an in-depth understanding of the Financial Planning mechanism and how to mould it for your goals. I am confident that with these weapons, you can conquer your financial goals with ease.
