One of the major steps of financial planning is to convert your financial goals into a financial plan. To make it simpler for you to understand, let’s have a look at the following pyramid, which shows the hierarchy of investment needs:
The pyramid clearly shows that before we start planning towards our short and long-term goals at the high-end of the pyramid, we need to start providing for contingency funds, life insurance cover, and health insurance cover.
Let’s start with the base of the pyramid – contingency funds. Let’s first see how we can calculate the expense ratio for the contingency funds. It’s simple, just add the amount in your savings account, FDs, and cash on hand to arrive at Total Income. Now, just calculate the Total Monthly Expenses, which includes EMIs, household expenses, and insurance premia. Once you have both these totals, all you need to do to arrive at your expense ratio is to divide the Total Income by Total Monthly Expenses. Expense ratio gives you an indicative amount of contingency funds you need to keep for meeting your expenses in case of emergencies such as job loss or unforeseen sudden medical events. Ideally, salaried professionals should maintain 6 months and business professionals 12 months of expenses in contingency funds. The ratio is higher for business professionals because of variable nature of income while expenses remain constant.
Once you are ready with your contingency funds, you must have your life insurance cover, which includes critical illness and disability cover in place along with your health insurance cover, ideally a family cover. This gets you higher in the pyramid towards your short-term goals such as buying a vehicle, bike, or planning a vacation. You must start planning for them since they are the most immediate ones. Once you sort out your short-term goals, you can go higher in the pyramid towards your medium to longterm goals, which include buying your dream home, planning children’s education and marriage, and covering for retirement. The pyramid doesn’t for a second suggest that your short-term, medium-term, and long-term goals are not that important. All it suggests is that you need to cover for contingencies first before exploring your larger goals of life.
Now that you’ve converted your financial goals into a financial plan, all you need to do is to work out your investment plan to maximize your current earnings, implement your financial plan in phases as shown above, and review it periodically to see where you stand. Reviewing your financial plan periodically is vital because it lets you know whether your investments are reaping returns as per the plan. The ideal review period is on quarterly basis. However, you are recommended not to keep changing your
investments in a hurry, since stock market investments tend to correct losses in the long term. You can take that decision if your investments are off-track for at least three or more quarters, but it is advisable to consult your professional financial planner before you make changes to your portfolio.
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