Setup a Financial Plan
How to setup a financial plan? How does a budget work? How to allow freedom by budgeting?
FINANCE
7/15/20237 min read
"Picture this: You're 65, sitting on a beach, sipping a cocktail, with not a financial worry in your mind. Sounds like a dream? A strong financial plan can turn that dream into your reality. Discover the simple yet transformative steps to build a financial roadmap that could change the course of your life, starting now."
What is Financial Planning?
"Financial planning is the process of evaluating an individual's current and future financial state by using current known variables to predict future income, asset values, and withdrawal plans. This often includes a budget which organizes an individual's finances and sometimes includes a series of steps or specific goals for spending and saving in the future."
Why is Financial Planning Crucial?
Ensuring Financial Security: To provide financial security and peace of mind both for the present and future by ensuring there are adequate funds available for different life stages and unforeseen events.
Achieving Financial Goals: To help individuals and organizations set, prioritize, and achieve specific financial goals, whether they're short-term (like buying a car) or long-term (like retirement planning).
Efficient Utilization of Finances: To make the best use of available financial resources by avoiding wastage, reducing costs, and maximizing returns on investments.
Risk Management: To identify potential financial risks and establish strategies to mitigate or manage them, often through the use of insurance or diversification in investments.
Creating a Budget: To keep track of income and expenditures, ensuring that spending is in line with priorities and doesn't exceed income.
Debt Management: To effectively manage and reduce debts, avoiding high-interest costs and the potential pitfalls of excessive borrowing.
Savings and Investment: To ensure there are funds set aside for future needs, emergencies, and wealth generation. This involves determining the most appropriate savings and investment vehicles based on one's risk tolerance and time horizon.
Tax Planning: To ensure compliance with tax laws, take advantage of available tax incentives, and minimize tax liabilities.
Retirement Planning: To ensure that individuals have enough resources to maintain their lifestyle in retirement without financial dependency.
Estate Planning: To ensure assets are distributed according to an individual's wishes upon death and to minimize potential tax consequences for heirs.
Liquidity Management: To ensure there's always enough cash or liquid assets on hand to meet immediate and short-term needs.
Key Components of an Effective Financial Plan:
Budgeting and Expense Management:
The most important aspect of every plan is to understand the current situation. This means understanding where your current income is flowing. There are three main type of expenses that people usually underestimate or unintentionally blend out.
Recurring costs: Those small negligible costs that occur monthly and that add up without ever being actively noticed. Although small, once several subscriptions it gets hard to keep track on the running expenses. Especially the yearly subscriptions. Examples:
Netflix or other streaming subscriptions
Gym
Leasing
Debt payment
Big future expenses: Those are known significant expenses that can be planned for, but usually not so big as to get you directly in trouble. Often times saving for such expenses gets push back to later, because there is still time. Imagine how easy it could be, if the costs of that big expense were already all saved up when the bill arrives. Examples:
Taxes
Down payment for a house/apartment
Residual value payment for your car
Emergency expenses: Those costs are absolutely unknown and could occur at any moment. It could be due to some serious injury or a car crash, or a variety of incidents that could happen.
Debt Management:
Understanding one's debts is crucial for maintaining a healthy credit score and securing favorable loan terms in the future. Being aware of debt details helps in effective budgeting and prevents financial overextension. Grasping how interest accumulates enables prioritized payments, reducing overall costs. Knowledge of debts offers leverage in negotiating better terms with creditors. Ultimately, a clear understanding of one's debts minimizes financial stress and fosters informed financial decision-making.
Emergency Funds:
Emergency funds provide a financial safety net during unexpected events, preventing the need to accrue debt or tap into long-term savings. They offer peace of mind, ensuring immediate expenses can be met without derailing one's financial stability. Having these reserves allows individuals to navigate life's uncertainties with confidence and security.
A rule of thumb in the financial world is to have 3-6 months of living expenses in cash as an emergency fund.
Retirement Planning:
Starting early for retirement planning harnesses the power of the compound effect, where even modest savings can grow exponentially over time due to earned interest on both principal and accumulated interest. With the aging global population, traditional pension systems are under strain, as fewer working-age individuals support a growing retiree base, leading to potentially reduced pension benefits in the future. Thus, early planning ensures not only maximized growth of personal savings but also counterbalances the uncertainties and potential inadequacies of future pension provisions.
Investments:
Investments hold a central place in financial planning as they serve as the primary mechanism to grow wealth beyond the rate of inflation, ensuring that savings don't lose real value over time. Through strategic asset allocation and diversification, investments can optimize returns based on one's risk tolerance, time horizon, and financial goals. Properly integrated into a financial plan, investments can facilitate the achievement of various life objectives, from purchasing a home to ensuring a comfortable retirement, making them indispensable in the pursuit of long-term financial security and wealth accumulation.
Investments can be viewed as the allocation of funds from one's budget that isn't directly tied to sustaining their chosen lifestyle. These are surplus funds, set aside after covering all essential living expenses, that one is willing to place at risk for potential future returns. While investments aim for growth, there's an inherent understanding that the market can be unpredictable and there's a possibility of loss, making it vital to only invest what one can afford to lose without compromising their current way of life.
Common Mistakes to Avoid:
When embarking on financial planning, several common mistakes can impede one's financial journey. Procrastination is a frequent culprit; delaying financial decisions or savings can significantly reduce potential compound growth over time. Many individuals fail to establish clear, realistic goals, leading to unfocused and ineffective strategies. Additionally, neglecting to periodically review and adjust one's financial plan can result in misalignment with changing personal circumstances or market conditions. Overlooking the importance of diversifying investments can expose individuals to unnecessary risks, and neglecting to account for inflation can erode the purchasing power of savings. Lastly, inadequate research or a lack of understanding can lead to misguided decisions and missed opportunities.
Steps to Get Started with Your Financial Plan:
Assess your current financial situation. To get started you can find the following simple excel template to help you get started in your assessment.
Set clear, measurable goals. Sometimes long-term goals are hard to quantify over an extended period of time. Those long-term goals should be broken down to clear measurable short-term goals.
Commit to regularly reviewing and adjusting your plan.
Dynamic Life Changes: Our lives are in constant flux. Career changes, familial circumstances like marriage or the birth of a child, health issues, or unforeseen expenses can significantly impact one's financial standing and goals. Regular reviews ensure that your financial strategy remains aligned with these evolving life stages.
Market Fluctuations: The financial market is inherently volatile. Assets like stocks, bonds, and real estate can undergo significant value changes over short periods. By periodically assessing your investments, you can capitalize on profitable opportunities and mitigate potential risks.
Goal Reassessment: As you progress in life, your financial goals might evolve. Perhaps you've achieved certain milestones earlier than anticipated or encountered unexpected roadblocks. Regular check-ins allow you to recalibrate your objectives and the strategies to achieve them.
Inflation and Purchasing Power: The value of money doesn't remain static. Inflation can erode your purchasing power over time. By consistently revisiting your financial plan, you can ensure that your savings and investments grow at a rate that outpaces inflation, preserving the real value of your wealth.
Tax Implications: Tax laws and regulations may change, and new financial products or opportunities might emerge that offer tax benefits. A routine review ensures you're optimizing tax-saving strategies and remaining compliant with current laws.
Optimizing Returns: Investment portfolios can drift from their original allocation due to differing returns on asset classes. Regularly rebalancing your portfolio ensures it aligns with your desired risk tolerance and asset allocation, optimizing potential returns.
Accountability: Setting a schedule for financial reviews fosters discipline and accountability. It's a self-check mechanism to ensure you remain on track and make proactive adjustments before small deviations become significant detours.
Conclusion
In conclusion, the journey of financial planning is a marathon, not a sprint. The undeniable power of starting early leverages the compounding effect, turning even modest savings into substantial assets over time. However, while early planning undoubtedly offers a strategic advantage, it's imperative to remember that it's never too late to begin. Each step taken towards financial preparedness, regardless of when it's initiated, paves the way for a more secure future. Whether you're taking your first steps in your twenties or recalibrating in your fifties, the key is to start now, armed with knowledge and determination, and to stay consistently engaged with your financial aspirations.
Additional Resources
BOOKS
"Rich Dad Poor Dad" by Robert T. Kiyosaki: This book offers fundamental lessons about money, work, and life, contrasting the financial philosophies of Kiyosaki's "Rich Dad" and his biological "Poor Dad."
"I Will Teach You to Be Rich" by Ramit Sethi: A six-week personal finance program for young adults, covering banking, saving, budgeting, and investing.
"The Millionaire Next Door" by Thomas J. Stanley and William D. Danko: Through surveys of millionaires, this book uncovers the common habits and choices that have led to their wealth.
“The Psychology of Money” by M. Housel: This book offers unique insights into how people perceive and interact with money. Rather than delving deep into numerical strategies or specific investment techniques, Housel emphasizes the emotional, psychological, and behavioral factors that influence one's financial decisions.
Name of Budgeting Apps
Mint: Developed by Intuit, the same company behind QuickBooks and TurboTax, Mint allows users to track their spending, set up budgets, and get a complete picture of their finances.
You Need a Budget (YNAB): This app focuses on giving every dollar a job. It's based on zero-based budgeting principles and encourages users to be proactive about their spending.
PocketGuard: This app offers insights into how much you can safely spend by analyzing your income, expenses, and financial goals.
Goodbudget: Based on the envelope budgeting method, this app lets users allocate specific amounts of money to particular categories or "envelopes."
Personal Capital: More than just a budgeting tool, Personal Capital offers investment tracking and retirement planning features.