Personal finance is a broad umbrella that covers a plethora of activities. Personal finance is incredibly relevant today since it helps to make conscious decisions on budgeting, insurance, mortgages, banking, cash management, retirement planning, investments, and tax planning. It is often used interchangeably with the industry that is mainly involved in providing financial services to individuals and advising households on financial and investment opportunities. A well-organized personal finance plan is a boon for the bright future of an individual.
In recent times the concept of family-oriented financial planning has been gaining a lot of traction in various parts of the world. It plays an essential role as family incomes have a significant influence on the economic environment. Financial planning depends on the income of the family as a whole, their living standards, lifestyle, their goals, and devising a plan to realize those needs within the financial limitations. It is, therefore, not astonishing to see that this discipline is expanding at a fast pace in both developed and developing countries.
Personal financial planning starts with outlining some goals taking all savings and investments into account. Correspondingly it requires considering financial short term and long-term goals and different parameters associated with financial risk management. Personal financial activities include income generation, spending, saving, investing, and protection.
Income refers to the inflow of cash/funds that an individual earns and uses to meet his and his family’s needs and requirements. An individual can either use this to spend, save, or invest, making it the first step in a personal finance roadmap. Spending constitutes all types of payments made by an individual to buy goods and services or any expenditures that are not in the form of investments. Spending can be mainly categorized in two ways: Cash and credit (i.e., paid for by borrowing the money). Disciplined spending habits are critical for sound personal finance management. Any income over and above spending is known as saving. However, having excess saving is sometimes considered negative since it earns little to no return compared to investments.
Investments refer to purchasing assets with an expectation of earning a reasonable rate of return and receiving more money than initially invested. However, investments carry risk, and some assets may end up on the losing end, making it essential to factor in both risks and returns before making a decision. Protection relates to funds set aside for safeguarding against an unforeseen event. A detailed analysis is needed to assess an individual’s insurance needs before making any decision.
As the adage goes – “Failing to plan is planning to fail” – it is crucial to start financial planning as soon as possible to give yourself and your family a secure future. So it is essential to manage personal finance requirements at the early stage. Since you have more time in hand to invest in long-term policies. The same policies, when entered into at an early stage, might give higher returns than when entered into at a later stage. Start small, but start early, increase your savings slowly, building a corpus that you might enjoy during post-retirement life.
Budgeting is an essential part of personal finance. Budgeting helps in evaluating the financial situation, which, in turn, supports in assessing financial health. It is suggested to maintain the 50-25-25 method, i.e., allocating 50% of your income (net of taxes) for the essentials, 25% for meeting lifestyle expenses and the last 25% for the future, i.e., saving both for a stress-free retired life and for meeting uncalled for emergencies. It is equally important to plan for an emergency fund. This fund needs to be maintained over and above the regular saving of 25% of the take-home pay that has been suggested.
It is always advised to desist from excessive credit. Treating plastic money as a favored alternative for meeting expenses can prove disastrous. Credit needs to be managed efficiently; the balance should duly be paid off within the due date, and a crunch, if any, should ideally be kept at a maximum of 25% of the credit limit. A bad credit score is a tool that can ruin credibility and leave in flux when a necessary need for funds arises. It is correspondingly imperative to maximize retirement savings and reallocate savings based on performance concocting a risk-free strategy.
Keeping in line with the above, one should maintain the right balance between savings and investments while also allocating an optimum amount of funds towards the protection of the individual and family. To create a diversified portfolio, one needs to distribute one’s capital across different categories of assets. Including a varied mix of growth and defensive assets will ensure good return while also considerably reducing risk.
(By Dr. Naliniprava Tripathy, Professor (Finance), IIM Shillong)