The basic rule of the pyramid is to start from the bottom and move up, rather than attempting to address all aspects of it at once
It’s often said that Financial Planning is “simple, but not easy”. Indeed, it’s a fact that the basic tenets of Financial Planning are relatively straightforward – the ease of adhering to them is a different story! While thumb rules and simplistic frameworks for Financial Planning abound, the “pyramid approach” stands out as the clear winner.
What is the Financial Planning Pyramid?
The Pyramid is an approach to managing our personal finances. The basic rule of the pyramid is to start from the bottom and move up, rather than attempting to address all aspects of it at once. The four levels of the pyramid are (starting from the bottom): protection, savings, wealth building and speculation.
“Protection” forms the base of the Financial Planning pyramid, and therefore must form the base of any good Financial Plan. Put simply, protection involves “covering your bases” by taking out an adequate quantum of insurance coverage to safeguard yourself from the risk of your financial loss arising from damage to your assets or to your health.
Additionally, protection also encompasses having enough life cover in place to indemnify your dependents from the financial loss arising from the loss of your life. Lastly, protection involves having a controlled amount of debt, and steadily reducing (if not avoiding) expensive debt altogether. For instance, it’s an exercise in futility to save money for your future goals while incurring wasteful interest costs on your credit cards – you may as well channelize the savings amount towards retiring your expensive loan first.
Once you’re done covering your bases, you can consider saving for your future goals. A well drafted Financial Plan should form the cornerstone of your goal based savings, as it would allow you to take a more holistic stance towards your financial goals, keeping your cash flows, liabilities, and goal priorities in mind.
Start making affordable, regular and disciplined savings towards your important life-goals such as purchasing a home, planning for your child’s education, or planning for your own comfortable retirement.
The quantum of savings need not be large – what’s important is that you make a start early on so that you give your funds the chance to compound over time and grow exponentially. For instance, did you know that a monthly saving of Rs 10,600 for 25 years (Rs 32 lakh overall) can grow to Rs 2 crore at a conservative 12 per cent annualized return? What’s more – delaying this savings plan by 5 years will reduce the final savings amount from Rs 2 crore to Rs 1 crore! Ideally, your savings plan should also have automatic step up mechanisms built into it, to ensure that your goal linked investments go up in sync with your increasing surplus.
Having put your savings plans on autopilot, you should utilize windfall profits (such as year end bonuses, inheritances and business profits) by investing them in a diversified portfolio consisting of high quality asset classes such as blue-chip shares, real estate, long term track record mutual funds and bonds. Consider your unique profile and preferences before you invest for wealth creation. Your investments need to be in line with the asset allocation that best suits your risk appetite.
For example, if you are a conservative investor, you should probably have only 20 per cent of your investments in equities, 50 per cent in debt and fixed income products and the remainder in real estate and/ or gold. A more aggressive investor may have a different asset allocation altogether. Younger investors should ideally adopt more aggressive stances towards their portfolios, even if their risk tolerance levels are low.
As the term suggests, speculation is basically no different from betting or gambling! An example of speculation would be trading in shares with the intent of selling them in a week or two, or making speculative, leveraged trades into futures and options with a short-term horizon.
Though speculation may lead to washout losses or windfall profits, one need not avoid it altogether – it is, after all, the only really exciting aspect of Financial Planning! It is advisable, though, to speculate last of all (after taking care of your protection needs, savings and investments).
Another thumb rule of speculation is to do it with moneys that you can afford to lose in entirety. That is, if the money value of these speculative were to unluckily become zero, it will not cause you any significant distress or financial strain. The mistake most people make when it comes to speculation is that first, they speculate with their entire free surplus and second, they speculate before taking care of their higher priority financial planning needs first.
This article is rightfully owned and posted originally by Anirruda Bose.