What is Financial Planning All About

What is Financial Planning All About

It may seem a bit far fetched, but some investors have butterflies in the stomach when they hear about financial planning. There is no doubt that planning one's finances is a very necessary and beneficial practice, but what does the plan really entail? I feel strongly that a good answer can help to calm the fears of investors.

Financial planning basically involves making decisions in five main areas: budgeting, liquidity management, management of large purchases, long-term investment and insurance.

In budgeting, the investor is supposed to decide how much of his income will be saved and how much will be spent. When income exceeds expenditure, there is saving, and hence an increase in assets. When the reverse occurs, there is negative saving, or a rise in liabilities. The excess of assets over liabilities represents the net worth of the investor.

Saving broadly relates to three different time horizons. Short-term saving such as saving for day to day expenses has a connection with liquidity management which will be soon discussed. Medium-term management deals with saving for items such as a car, or deposit towards buying a house, and borders on financing large purchases. Long-term saving is needed to achieve long-term investment.

Liquidity stands for cash that can be readily spent. Generally speaking, the more liquid a financial instrument is, the lower the returns it provides. Examples of very liquid instruments are bank notes, and chequeable accounts. These instruments pay little or no interest. Bank and building society deposits are slightly less liquid instruments that pay some interest but with some amount of limitation in accessibility. Stock market securities such as shares and bonds provide much higher returns but are equally much less liquid. It is necessary for an investor to decide how much of his saving should be in very liquid form and otherwise, in order to maximise returns.

Some form of money management is needed. For example, the high dealing cost involved in the purchase and sales of shares will make it unreasonable to embark on a share investment, when one is saving towards a holiday. A deposit or chequeable account will be more suitable. Liquidity can also be maintained via the use of credit cards, except that this form of credit attracts high interest. One must decide as to how much of liquidity will be provided by credit cards, through credit management.

When considering large purchases such as buying a car or house, one can use his own savings, borrow or combine both savings and borrowing. It pays to bear the interest as well as duration of repayment in mind when borrowing. Allowance should be made for possible hikes in interest, and a resultant rise in the size of the loan, and regular payments.

Returns increase more than proportionately with time, and risk increases less than proportionately with time when considering investment in shares. In other words, shares are more suitable for long-term investment than many other securities. There is time diversification which means that losses are evened out by gains with the passage of time. Another benefit of employing shares in long-term investments is their ability to nullify the negative effects of inflation. Shares have been proven to provide returns that are proportionately higher than inflation in the long-term.

Insurance is also considered in financial planning and essentially means paying money to an insurer for financial protection. Life insurance protects the beneficiaries in the event of the death of the policyholder. In fact insurance can be taken out to cover various assets such as car, property, and so on. It can provide protection against eventualities such as critical illness, sickness, income continuity during death and so on. Certain insurance policies such as endowment and whole-of-life combine both features of savings and life insurance in one package. It is wise to decide during planning whether it is better to keep savings and life insurance apart.

Financial planning should be demystified. It is like any other plan, except that it relates to finances. As long as one stays focused and methodical, and touches on the aforementioned decision zones there shouldn't be any anxieties. The plan is for a particular individual to use and it is crucial that decisions are made to suit the unique financial situation and circumstances of the person under consideration.