Over the last few years, the term “financial planning” has been very often used and heard by many of us. In this article, we explore as to what this term means and why it is important for us all.

What is financial planning:

Simply put, financial planning is the process of meeting your life goals through the proper management of your finances. The life (read financial) goals can include buying a home, saving for your child's education & marriage or planning for your retirement or protecting your family. It is a process whereby a qualified financial advisor will consider your entire financial situation and goals and provide you with appropriate action steps to fulfil your goals and better manage your finances. It is not a one-time process but is continuous in nature as your life situations and finances change over time. You also need to regularly review your financial plans & your investments to ensure that you are well on track to meeting your financial goals/objectives.

Why financial planning is needed?

Given the nature of today's life, with growing uncertainty, rising aspirations and increasing costs of living, doing thorough financial planning have become a must for each of us. It is also better to plan and be ready for any situation rather than be passive and wait for things to happen before doing anything about it. A special case to mention is of Retirement planning, which has become very critical since the average life expectancy has increased and appropriate planning is needed to ensure that your 20-30 years of your life after retirement is dignified, peaceful and self-reliant. 

In the absence of proper financial planning, the following are the risks faced by a client.

• Continued lack of understanding of your financial situation

• Delay and wastage of critical time for planning for goals

• Continued exposure to financial risks in life to you and family

The financial planning process:

The financial planning process is a logical, six-step procedure from the perspective of a client.

1. Establish and define the relationship: The first step is establishing a relationship with the financial advisor/expert. The client should inquire about the services offered and the process. The client should also inquire about the professional’s competencies and experience. The client should also enquire about any fees and how the advisor would be remunerated from the same. The client should make clear any expectations he/she has with the advisor/expert.

2. Sharing of information: The next step would be the identification of your personal and financial objectives, needs and priorities that are relevant to the scope of the engagement before making and/or implementing any recommendations. The financial expert would request sufficient quantitative and qualitative information and documents from you relevant to the scope of the engagement before making and/or implementing any recommendations.

3. Analysis and assessment of your financial status: The next step would now be to analyse your information, subject to the scope of the engagement, to gain an understanding of your financial situation. The step involves assessment of strengths and weaknesses of your current financial situation and compares them to your objectives, needs and priorities.

4. Development of financial plan recommendations and presentation: The next step involves the financial planning expert considering one or more strategies relevant to your current situation that could reasonably meet your objectives, needs and priorities. Then the financial planning recommendations based on the selected strategies will be developed and presented to you. You may seek to understand the supporting rationale in a way that allows you to make an informed decision.

5. Implementation of recommendations: Once you have understood and given your approval to the recommendations, the execution will happen. Note that the expert would expect your agreement on implementation responsibilities that are consistent with the scope of the engagement. Based on the scope of the engagement, the expert identifies and presents the appropriate product(s) and service(s) that are consistent with the recommendations accepted by you.

6. Review your financial situation: The expert and you would then mutually define and agree on terms for reviewing and reevaluating your situation, including goals, risk profile, lifestyle and other relevant changes. While conducting the period review, the expert along with you will review your situation to assess progress toward achievement of the objectives of the recommendations, determine if they are still appropriate, and confirm any revisions mutually considered necessary.

Advantages of financial planning:

To summarise, the following are the key reasons or benefits that you would get from financial planning.

• Proper understanding of your financial situation

• Finalisation of the financial goals and knowing what it would take to achieve the same

• Understanding your insurance needs and ensuring financial security

• Understanding how your financial decisions and choices will impact your financial well-being

• Having a path laid out for you and your family's long term financial well-being

Most of us do not have adequate information about financial planning and only in recent years has there been some growing awareness about it. Most of us though still believe that they are knowledgeable and smart enough to decide upon their finances on their own ignoring the fact that this is a very broad subject that requires professional expertise. We are ready to visit and pay an accountant, doctor, lawyer or any other professional but are shy when it comes to asking for a financial plan from financial experts. A better, secured financial life is a dream for all of us which, with proper financial planning, can become a reality. The need is to understand this crucial part of our life and give it the importance and priority it deserves.

No one can predict equity market. Right? But the other side of the coin is that no one can create wealth by ignoring equity market. Equity market becomes more predictable with the increase in investment horizon, and we have discussed and proved this on many occasions. The fact of the matter is that equity is best suited to help investor meet financial goals in life with the potential of generating inflation beating return, but another equally important fact is the inherent volatility of equity, specially in a short term of less than 5 years.

Financial goal based investing is at the core of any investment exercise., After all we all save and invest to achieve a specific goal or need in life, which can be to provide good education to our kids or to spend on their marriage or simply to have peaceful, worry free retirement. With the right advice of your financial advisor, you invest in the right asset class, generate return as expected or even exceed that, and reach the desired corpus required to meet a specific goal, but imagine a situation when equity market crashes just few months before you actually need that money, or a bank/company goes bankrupt in which you had put fixed deposit. Remember co-operative banks and many companies going bust in late 90s or recent crash of equity market in 2008.

Lets imagine Mr. Shah, who had been investing in diversified equity funds through SIP for last 10 years to save for his son's higher education, which was due in 2009 for which he required to pay fees in March/April 2009. He was a happy man in September 2007, as he had not only built the required corpus, but in fact had exceeded due to strong market rally and super performance of equity funds in which he had invested. His joy multiplied manifold in January 2008 with the increasing value of his portfolio. This strong rally of equity market tempted him to continue out of sheer greed to earn more. But come March 2009, his portfolio was down by more than 50% and he had to arrange for his son's fee from other sources.

Time Horizon and Risk Factor
These two are inversely proportionate to each other in case of equity investment. As investment horizon increases, risk reduces, and vice versa. Equity investment can prove highly risky with anything less than 3 years of investment period, but becomes more predictable with reasonable period of above 3 years. A common mistake that investors make is, they try to chase equity return in short term and lock long term money in fixed income product like PPF for 15 years. Ideally it should have been the reverse.

As can be seen from the below graph, if someone invests Rs. 50000 every year in both PPF and equity fund, over a period of 20 years, then equity fund clearly outperforms PPF. At the end of 20 years, an investor makes Rs. 24.71 lakhs in PPF while the same amount grows to Rs. 58.9 lakhs in equity fund.

Let us try to understand by putting numbers in the above example of Mr. Shah. Lets assume that he started SIP in 1999 and he wanted Rs. 7 lakhs for his son's education, when he reaches 17 years of age in 2009 (in approx 10 years time). His monthly SIP need was Rs. 2868 so he started with Rs. 3000 of SIP (assuming modest return of 13% per annum).

Eventually he got return of 20% during period of 1999 to 2008 and reached the figure of Rs. 7 lakh in the beginning of 2008. (when SENSEX was touching 20000 for the first time). Greed overtook rationality, and Mr. Shah wanted to cash in market rally and continued with his equity investment. We all know what happened to equity market between January 2008 and March 2009, when he actually wanted the money. SENSEX was down by around 50% and so was his portfolio.

Isn't this a very practical example? Many times we come across this kind of situation, when we find equity market at a low level, specially when we have need of the saving. What to do in this kind of a situation?

Conventional wisdom says that one should start shifting money from equity to debt as one reaches near his/her financial goal. Considering the inherent volatile nature of equity, it is always prudent to shift corpus from equity to debt, and ideally the entire amount should be in debt for at least 1 to 2 years prior to the actual need. This can ideally be done in two ways:

Opt for Systematic Transfer Plan (STP)
This is the facility available in mutual funds under which an investor can give standing instructions to transfer money from one fund to another. As one approaches the goal, STP instructions can be given to start switching funds from equity to short term/liquid funds to protect any potential downside from equity.

Shifting: As discussed, switching of invested money should ideally start around 1-1.5 year prior to the actual goal. As the objective here would be to protect any downside and not return optimization, short term/money manager funds can be an ideal option or one can also look at 1 year fixed maturity plans (FMP).

The idea here is to protect the funds created over the years. When you start investing, focus on equity, take maximum advantage of power of compounding and invest through SIP over the years. Switching to liquid/short term funds should start either as soon as investor reaches the desired amount or at least 1.5 to 2 years prior to the actual goal.

E.g. With our example of Mr. Shah, he could have started switching funds from equity to short term money market funds in the later part of 2007, as he reached his desired amount of Rs. 7 lakhs or could have simply put that money in 1 year FMP product. This would have not allowed him to participate in future rally but at least his money would have been secured and even during that 1 – 1.5 year period money would have generated inflation beating return.

Ideally, it is advisable to shift the amount required for a specific goal to liquid/short term funds at least one year or year and half ahead of actual requirement to protect any downside or it can be done as soon as required amount is reached, irrespective of the time horizon. Whatever path you take, prudent investment approach suggests to realign your portfolio in favour of debt to protect the amount you have built to meet your specific goal.

As kids we would have read the famous story of Alice in wonderland. In the story, she once reaches a crossroads and was not sure which road to take. A passing cat asked her where she wanted to go to which Alice replied

"I don't know!". The cat then smilingly replied "Then it doesn't matter which road you take".

The classic moment in the story is true to each of us in our daily lives. In our lives too we are often at crossroads like Alice and unknowingly we choose our roads without knowing where we want to reach in our life. When it comes to investments, this is in fact the reality for most of us. Since we don't know what we want to achieve from our investments, any investment decision helps us achieve it.

The need for setting goals can never be undermined, be it business, personal life or your personal finance. Every wise investor would know the purpose or objective behind his/her investments and more often than not, the same would be geared towards achievement of some goal in life. The goal can be any personal or financial goal like retirement or a fixed amount at any time in future, with the condition that it can be monetised or spoken in terms of money.

Advantage of setting goals:
The following are some of the benefits of setting financial goals in your life...

• Goals make you think & prioritise: When you actually start planning for your goals, you are forced to evaluate the need, intensity and priority for each of your goal in life. This gives you a lot of clarity on which goals to pursue and in what priority. Often important goals which are not on the top of your mind, crop up and make you think.
• Goals make you take action: After identifying goals, one becomes more inclined to take actions for achieving the goals. We often neglect or delay the action because the goals are not very clear in our minds. Defining goals would help you realise the urgency for taking appropriate actions
• Goals tells you where you: Unless the goals are defined, we would not be able to comprehend our current situation with regards to the future. Defining goals also clarify their feasibility and practicality for achievement and accordingly, depending of our current situation, we may either change the maturity period or the returns expectations or the targets of the goals.
• Goals helps you to keep focus: Understanding your goals would help us keep focus on achieving them. This helps us on a daily basis and you may start making a choice between making small expenditures or saving for the goals. Also, we would be more discipled and regular in making our investments and at the same time, not withdrawing from the kitty saved towards the goal.
• Goals lead to success: With goals in mind, you will make optimum use of your financial resources when while planning for them. You would eliminate wastefull expenditure, invest in productive asset classes and tend to maintain discipline in your investments. All these factors ensure that you are much closer to your goals then they mature.

Risks of not setting goals:
Just like we discussed the benefits of goal-setting, there are similarly down-side risks to not setting and planning for goals.

• Compromise on goals: Not identifying or delaying planning for your goals for too long would ultimately lead to situations wherein you would need to either compromise on your goals, in terms of value or by pushing our goals into future. However, more often than not, goals like child marriage, education, retirement, cannot be postponed and it is best left unsaid as to how you would plan when they actually arise. You may even loose out on smaller goals & moments of happiness like say vacations, which would be very much possible if you are planning in advance for them.
• Failure to make optimum use of finances: Not setting goals and planning for same will lead to misdirected investments and spendings. Chances are that there would be unwarranted spending which would had been invested had planning been done. There is also high chances that you would save in asset classes or product which are not in line with your goals. For e.g., While planning for retirement after say 15-20 years, you will probably identify equity as ideal asset class for you to invest. However, in absence of same, you may avoid equity investing as a risky asset since your goal & time horizon is not clear.
• Compromising on Long-term financial well-being: In long term, better management of your resources would enable you to achieve same while also creating and protecting your wealth at the same time. Needless to say, you are more likely to be credit-free, while having appropriate wealth at disposal for a better life, especially post retirement. By avoiding goal setting & planning, you may well be inviting financial in-stability or insecurity in long-run since you may be forced to take credit or dilute your unplanned investments when your goals mature.

Setting financial goals is something that we are not completely unaware of. It is like basic common-sense. We all know its importance but rarely do we plan and act accordingly. We have discussed in detail the benefits and risks of not setting your goals and planning for them. Very clearly, they have potentially very far-reaching & defining consequences to your financial well-being in future. Those who are wise would understand its criticality and start taking appropriate actions towards it in immediate future. And for those who fail to do would leave matters increasingly to luck and chance for as long as they continue delaying same.

Asset Class is a often used word in finance, especially investment & portfolio management. We also used the term many times in our articles. In this article a take a academic look at the various asset classes.

We all aim for success in our investments. But success in any investment is a play between returns & risks. You may not have any control on the returns or risks that your investment portfolio actually generates but you definitely have control on making a smart allocation that maximises returns and minimises risks. While planning your investments, 'risks' is often not properly understood and even less planned. This article introduces you to this aspect of planning in your investments.

Planning for investment risks or “Risk Management” is nothing but the identification and assessment of risks followed by smart allocation of money in such a manner that the chances of an unfavourable outcome and/or the losses because of same is minimised. Risk management also involves regular monitoring and rebalancing your portfolio to control such risks.

The steps in any risk management exercise, including investments, would be as follows:

• Know the risks faced - identify, characterize and assess threats
• Understand the risk involved – determining the extent of risks & probability of occurrence
• Identify ways to reduce risks
• Prioritize & act on risk reduction measures
• Regularly monitor & control risk

The third step involves identifying different ways to reduce risk. A smart person knows that 'not taking any risk' is also risky and that deciding to not take any action is also an action in itself. Risks management strategies can be broadly classified in the following 4 ways:

• Avoidance - eliminate or withdraw the source of risk or in other words, do not take exposure to risks
• Reduction - mitigate the risks faced by smart strategies
• Sharing - transfer or share the risks, i.e., insure yourself from same, if possible
• Retention - accept and budget for risks

An investor can adopt any combination of the the risk management strategies while managing his investments. While strategies of Avoidance, Sharing & Retention are largely self explanatory, we take a closer look at the strategy of Reduction, which we believe is much more relevant and meaningful to investors. Risk Reduction would entail strategies whereby you can reduce the overall risks in your portfolio while not compromising on your returns potential. A few of the smart strategies for the same are listed below for your consideration...

• Diversification: Even as a child we learnt that we should not keep all our eggs in one basket. This same principle also applies to investments. To reduce risks, we must diversify our portfolio / investments into appropriate mixture of different asset classes, products and companies / sectors, etc. To begin with, we must take a complete picture of our entire portfolio before we start with diversification. As earlier said, diversification can be in various types and ways. For example you may well diversify your portfolio into equity / debt / commodities / real estate, etc. at the higher level then say within equities, you may diversify into direct equities, mutual fund equity schemes, etc. and further even diversify into large-cap or mid-cap, sectoral or theme companies or funds. Diversification must be such that the portfolio is easy to manage and monitor. One of the good ways to diversify, if you are investing directly into equities or debt products, is to invest in mutual fund schemes which may be equity, debt or cash oriented.

• Asset Allocation: While the diversification principle tells you to spread your investments into different asset classes, products, etc., Asset Allocation provides the tool which you can use to properly balance your portfolio to get the best risk-return trade-off suited to your risk appetite. Every asset class has a peculiar returns expectation, risk in terms of volatility of returns and an ideal time horizon for investment. Further, different types of investment instruments respond differently to the changing market conditions, varying political and economic scenario.
  Asset allocation is allocating your investment into different class of assets which usually have no correlation with one another. One can thus be assured, upto an extent, that even if one type of investment doesn't perform, the portfolio will he hedged due to the investment in another type of instrument which may fare well.
  For example, in a booming market, one can increase allocation to the stocks as the strong corporate earnings and relative stability will increase the value of stock holdings. On the contrary, in a rising interest rate scenario; investors would wish to increase their allocation in bonds, reduce allocation in equities and keep a crtain position in cash. Hence, modifying one's asset allocation from time to time will help minimize losses in different economic situations depending on which asset class looks favourable or otherwise.

• Rupee Cost Averaging: The Guru of value investing, Benjamin Graham, trusted dollar (or rupee) cost averaging as the most effective way for investors to reduce the risk of fluctuation in asset prices. More relevant to investing in equities, rupee cost averaging is nothing but the practice of investing a fixed amount every period (month, quarter, or any period) in an asset. This strategy ensures that you are investing small amounts at all prices reducing the price risk involved to a large extend. Further, as studies show, the periodic investment averages the purchase price of the asset such that the average purchase price is often lower than the market price. SIP or Systematic Investment Plan in a mutual fund equity scheme is one very popular way of investing based on this strategy of risk reduction.

• Portfolio Management: The strategy simply requires that your portfolio must be very professionally managed and monitored at regular intervals and that investment decisions must be driven by proper research and analysis. This would keep risks controlled on your portfolio. However, doing this on a sustained basis is not easy for common investors. The investors can however take assistance of experts and professionals like 'wealth managers', 'financial planners' or 'portfolio managers' for managing their portfolios and guiding investment decisions. Often such professionals/ experts have relevant experience in the field and have more knowledge and resources dedicated to this work which cannot be matched by common investors. Investors would be advised to even pay fees such professionals / experts for services in order to get unbiased and high quality services. Over time, one can surely reap many times profits in terms of better investment decisions and reduced risks through professional portfolio management services.

• Hedging: Hedging is another strategy of reducing risks suited and used by more advanced investors. Under this strategy, the investor exposed to risk in one asset class or product would take an opposition position or exposure in say future & option contracts. The idea is that if the investor suffers losses in one investment, it will be offset by a profit in the other. Hedging is very commonly done with derivative products of futures & options.

Risk and return is inseparable so to earn a good return, having a proper risk management system in place is very crucial. Therefore, assessing one’s risk tolerance and time horizon is the starting point to following a proper investment plan and supporting it with risk management techniques. As investors, we must also understand that the risk that we seek to control is similar to everyone but the impact of same on us is subjective in nature and will be unique to our own peculiar situation. In other words, the 'risk' tolerance level for each of us is different and is dependent on one's age, income levels, assets, investment dependency, risk attitude, life-stage, etc. Risk attitude is something that shows how much comfortable are you in investing in products of different risk-return levels. You may like investing in equities and commodities for higher return while others may be interested in minimizing risk and earning a satisfactory return at the same time. In the end, the person who best understands and controls risks will never be on a loosing side. After all, successful investing is more about not making big mistakes rather than choosing winners...