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How to plan your finances
November 10, 2003 11:51 IST
Financial Planning is an activity the importance of which cannot be understated. We all know that. Unfortunately, we do not spend much time planning our finances.
One reason for this 'inactivity' is that we overestimate the effort required for planning our finances. And that too probably many times over.
On the contrary, financial planning is a relatively simple activity, which may not even require professional help!
What is financial planning?
Let's say you are salaried and just married. You already have a 'property', which in effect takes care of your most pressing need - a place to stay.
However, now you need to plan for two most important things - your retirement, and your children's education (both eventualities) i.e. you need to draw up a 'financial plan', which will help you meet your monetary requirements when your children go to college and when you retire.
Seems a daunting task. But is it?
Let's plan for your future
Let's take the first goal - planning for your retirement.
The most important thing to remember is that it is never too early to plan your retirement. The reason is pretty simple - the power of compounding (we will tackle this issue is in a forthcoming article).
Once you have decided to plan for your retirement, a smart way to begin is by estimating what is the amount of income that you will require when you retire to sustain your present life style?
Assuming your monthly expenditure today is Rs 100 p.m. and inflation is likely to average 5 per cent over the period. So, 30 years from now, when you retire, the corresponding monthly expenses would have ballooned to Rs 432.
Once retired your expenses will probably reduce. Nevertheless we will keep the expenditure amount unchanged - as the reduction in expenditure could be compensated by more travel and/or medical expenses.
Now we have a target and also the time frame in which we have to reach the same. This makes the process much simpler.
Let's take a look at some of the major investment avenues available:
- Fixed Income
- Pension / Life Insurance
How each asset class can help you meet your needs
Note that the role of each asset class will depend on your age and investment profile and there is no one size that fits all.
Equity is a very attractive investment avenue if one is investing for such a long period of time. Now it may seem pretty 'dangerous' to invest your 'retirement planning' money in the stock markets but don't jump to conclusions just yet.
Investing in the stock markets can be done in two ways - directly by purchasing stocks of companies listed on the stock exchanges or indirectly by buying units of mutual funds, which in turn invest in the stock markets.
Investing directly in the markets is advisable only if you are adequately experienced to make an investment call (alternatively you can use an investment advisor, but this will cost you a bit).
In most cases it is advisable to invest in mutual fund units.
Investing in mutual funds too is not a risk free exercise and some home work needs to be done before the actual investment is made.
One of the better options is to invest in an index fund (funds which invest in stocks which form a part of an index such as the NSE - 50).
Index funds have several advantages over the regular diversified funds:
- Since there is no need for an 'active fund manager' in such schemes, the expenditures are much lower - this in effect 'adds' to returns
- The fund manager is unable to use his discretion in investing in stocks - thus the risk of his making a wrong call is eliminated
- Finally, returns generated by an index fund track the markets very closely. Over time returns generated by low cost index funds tend to compare well with the more expensive diversified funds.
What is the kind of returns you can expect from equities over a period of time?
(NAVs as on December 11, 2002. Returns over 1-Yr are annualised)
|Diversified Equity Funds||NAV (Rs)||1-Mth||6-Mth||1-Yr||3-Yr||5-Yr||Incep.|
|FRANKLIN PRIMA FUND G ||28.1||6.1%||-3.8%||31.1%||-2.2%||26.0%||12.1%|
|ZURICH I EQUITY G ||21.8||8.8%||-4.1%||13.5%||0.1%||27.8%||11.0%|
|FRANKLIN I BLUECHIP G ||22.4||11.2%||-0.5%||11.7%||0.3%||27.6%||21.3%|
|FRANKLIN PRIMA PLUS G ||22.8||8.2%||-1.7%||9.7%||-4.4%||27.5%||11.9%|
|TEMPLETON GROWTH G ||12.6||8.3%||-4.5%||3.7%||2.1%||9.4%||5.7%|
|ALLIANCE EQUITY G ||24.9||11.9%||-8.6%||0.3%||-9.7%||NA||22.9%|
|BIRLA ADV FUND A ||23.5||6.8%||-11.4%||-3.1%||-20.1%||21.9%||15.3%|
|IDBI-PRIN INDEX (Nifty)||8.3||11.3%||-0.1%||-3.4%||-9.4%||NA||-6.0%|
The other investment avenue is Fixed Income securities like bonds and deposits. Here one needs to keep in mind that in such investments, the capital does not grow i.e. an investment of Rs 100,000 in bonds at face value will yield the same Rs 100,000 at maturity.
The benefit that will accrue in such investments is the interest income, which can be reinvested to benefit from the compounding effect.
Provident Funds fall in the fixed income category. At present such investments yield very attractive tax-free returns.
But here again the financial viability of such schemes is in doubt given the constant decline in interest rates (even as returns announced year after year stay stubbornly high). One should not go overboard with investments in the PPF.
|Instrument||Return (p.a.)||Tenure (Yrs)|
|Kotak Mahindra FD||8.25%||3|
|IDBI (Suvidha Deposit)||8.75%||3|
|8% Relief Bonds||8.00%||5|
The other major investment avenue is life insurance and pension plans. The attractiveness of investing in life insurance is two fold:
- An unforeseen eventuality takes care of your dependents' needs
- In case you were to live through the duration of the policy, you get tax-free maturity benefits.
Returns generated by life insurance policies may not be attractive, but as mentioned, they help take care in case any unforeseen eventuality were to take place.
However, there is one insurance product in the market today that is becoming increasingly popular - the savings bond, and rightly so. The reasons are not far to seek.
Let's take the example of the HDFC Standard Life's product. Here the investor has to pay 95 per cent of the sum assured as premium. The main attractions are:
- Tax free returns
- Returns are compounded annually (this makes effective returns more attractive).
- It basically functions as a balanced mutual fund, which has a down side protection i.e. the capital amount is guaranteed. Also, once the bonus for a year has been declared and attached to the policy, it is guaranteed (the value of your bond does not depreciate in case the insurance company were to announce a negative return in a year).
|* CAGR||9.97% p.a.|
Investing in a pension plan is another option. However one needs to bear in mind that though investments in a pension fund earn tax benefits (up to Rs 10,000 per year under section 80 ccc), the benefits i.e. the monthly income that accrues from the pension fund post retirement is not tax-free.
We have discussed some investment options and the returns they are likely to generate over a period of time.
Now depending on your risk profile, you need to allocate a large chunk of your money in these three options (other options include gold, et cetera).
For someone with a high-risk appetite, a higher exposure to the equity category is desirable, as over the long term, they will most certainly generate a much better return as compared to other investment options.
If done systematically the process of financial planning is simple.
However, one needs to devote 'regular' time to this activity - initially to draw up the plan and subsequently to evaluate it to ensure that you are on course to meet your objectives.
As a parting note, investors need to bear in mind that the age of assured returns is over. To earn higher returns, we need to take more risk.
The faster we adjust to this new regime, the better it is.