Sunday, November 18, 2007

For an average Indian such as me, school, college and post graduation have always been a path to learn skills and gain knowledge so as to secure a good job and start earning money. However only a few Indian actually understand time value of money and just how inflation can destroy ones savings over time. The banking channel is what most Indian have preferred and most probably will continue to prefer when it comes to savings and a bank loan will probably be the chosen path to meet aspirational needs such as a Maruti 800 or perhaps post 2008 the one lakh rupee car.

Build the Financial Plan around your Need Hierarchy

Since generations we have been told by our elders that by vigilant spending, saving & investing, one can meet the needs and life goals effectively. However the neo-generation has aspirations which have no end. Meeting one goal simply fuels an aspiration for a much higher and most probably an even costlier goal (from a Maruti 800à Alto à Wagon Rà Swift àà Maybach). In this situation it becomes imperative to prioritize our needs and goals, put our best efforts to meet each of them through proper management of our personal finance. And that’s what Financial Planning teaches us. Simply put financial planning begins with a Need Analysis followed by creation of a pathway which maps the financial resources to the goals and then simply following and updating the path.

Need Analysis
Prioritizing Needs forms the crux of any Need Analysis exercise. Maslow’s “Hierarchy of Needs” pyramid could be used to explain needs

Basic needs -->Contingency Planning

The most basic need our money can meet is taking care of our day-to-day living expenses like Food, Shelter, Clothing, Utilities etc. We should be in a position to meet them under any kind of contingencies and emergencies such as loss or change of job, physical disability, health problems, re-locating to new places, business losses or any natural disasters. Basic needs could be meet by a emergency fund in the form of bank balance in savings account, cash or short-term Fixed Deposits.

Security needs --> Risk Management

A human being is an income generating asset and this income may stop under circumstances such as death, physical disability and long-term health problems. Thus Life and medical insurance becomes important to protect this asset. After insuring the life, one has to cover the physical assets generated during the lifetime. Physical assets include House, Car and many of the valuable household items. Much of our income is devoted in generating these assets. Any loss demands replenishment which is a very costly affair and affects our other commitments in life. The General Insurance companies provide such covers.

Social Needs --> Planning for Financial Goals

Financial goals a scan be seen at two levels namely

  • Commitments such as providing decent accommodation for family, children’s upbringing and education, taking care of parents
  • Aspirations meant more to move up the ladder in society

These goals and dream can be met through a corpus created thru prudent investments into debt and equity as well as thru loans. Loans should be avoided in the absence of leverage (Return from investments funded by a loan e.g. House should exceed the sum of interest rate on loan plus inflation). There is a old saying that “Credit buying is much like being drunk. The buzz happens immediately and gives you a lift.... The hangover comes the day after”.

Self Esteem --> Retirement Planning

Retirees need a steady income to maintain the standard of living, meet post-retirement commitments and provide for medical expenses amongst others. The retirement corpus needs to be managed in such a way that it becomes a source of steady income and lasts for the lifetime. PF and pension funds have been traditional methods used for retirement planning in India.

Self actualization --> Tax & Estate Planning

Tax evasion is a crime in India but tax avoidance through legitimate means is not. As ones income and spending increases so does the tax bracket he/she is in. Tax planning should be done with a long term perspective and not on an annual basis keeping in view time-horizon of investments made to save taxes, salary structure opted for, liquidity concerns etc

Estate Planning means transferring our physical assets and financial assets to our next generation. A structured and carefully drafted Estate Plan not avoids legal hassles for the successors and bitter state of affairs among successors but also can reduce tax outgo.

As Mr Kini has rightly said if all inputs are properly validated and put into an equation the outputs always are perfect and optimized.

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