Financial Planning Examples Setting a financial goal is the simple first step in planning for our finances. Goals can be simple near-term ones like taking a holiday or buying a car. Or they can be long term goals like providing for children's education or ones retirement. All financial goals have to be defined realistically both for the time frame and the funds required. Assume we like to save for the education of our child, now 7 years old, but perhaps ready to pursue a professional course, 10 years from today. We know that we have to plan for funds for her education, and will need the money 10 years from today.
Assessment of needs We can begin with an assessment of how much money will be needed to fund this goal. We can do that by estimating the same, from numbers that we have today. We can put together the costs of, say an engineering education, today. Let us assume it is about Rs. 3 lakh a year, for 4 years. So we need about Rs. 12 lakhs, if the child were to study Engineering today. However, since the goal is 10 years away, we need to account for inflation, i.e rise in the cost of education. Let us assume a 5% increase in education costs per year. Then the amount of money we need 10 years from today will be approximately = 12 x (1.05)10 = 19.5 lakh We use the factor 1.05 to represent a 5% increase each year.
Target rate of return We are now ready to ask, how we like to accumulate this amount over time. If we are able to invest funds regularly, we should be able to take advantage of the growth in the value of our investments, to provide for this goal. The first cut off rate for us is the rate of inflation at 5%. It is important that our investment provided a return that is higher than this rate. Second, we need to ask how much are we willing to set aside for this goal. Third, we need to determine the kind of investment products that we like to use. Assume that we are able to save, say, Rs. 10000 a month for the education of the child. We have to now ask, what is the rate of return this investment should produce, to enable it to grow into Rs. 19.5 lakh in 10 years. We understand that our savings over 10 years would only amount to Rs.10 lakh and we expect it to grow into Rs. 19.5 lakh. The inherent return in this assumption is about 14% p.a.
Asset Allocation Assume that we have a choice of equity with a 20 % long term return, but higher risk; and debt with a 8% long term return but lower risk. If we are able to put these two together, we are able to look at a return of 14% and also balance out the risk. We can thus begin to invest in a product that provides a consistent long term return that enables us to meets our financial goal. Financial planning brings much needed discipline in our investments, and provides goal posts by which to judge whether our investment choices are aligned to our needs.