When Mihir nayak had a Highpaying job, his first priority was financial planning to secure his future. He was quite clear that he would have a surplus and wanted to put it to good use. However, he was not sure if he should buy insurance first or invest in equities and mutual funds which most of us feel. He had heard friends talk about how they multiplied wealth through equities. Mihir was grappling with a lot of unanswered questions. Should he opt for a life cover or health cover or both? Should he prefer direct equities or mutual funds? Should he commence his journey with insurance or investments? Mihir ’s situiation is what most individuals face at different points of time.
How do you resolve these differences? Let us break up the entire activity into a 3 step process and see how they fit in. Start with debt reduction and emergency fund Don’t jump directly into insurance or investment but start with reduction of debt. Focus more on high cost debt. For example, a home loan is low cost debt and it also offers tax benefits. However, other forms of debt like credit cards, personal loans are all high cost debt. If you are paying 35%
on credit cards or 19% on personal loans or 30% digital P2P loans; you are unlikely to create serious wealth even in the long run. Hence you must start your financial planning process by reducing high cost debt and set a 3-year plan to get out of high cost debt altogether.
Once the debt reduction plan is done and dusted, emergency fund is the next thing to focus on. This is liquidity and not an investment. So you set aside 5-6 months of income as an emergency fund in a liquid fund. You can start off with 3-months emergency fund and then expand it to 6 months. The idea is not to liquidate investments for emergency needs. Next, you must focus on adequate insurance You will notice that here the focus is on adequate insurance. The first step is to ensure health cover for yourself and your family. Here you should focus on a floater policy that gives better coverage for a lower cost. Life insurance must come after that. Don’t get carried away by the glib sales talk around endowment policies and ULIPs. Insurance is for risk cover and that is what it should be. How much risk cover should you take? The cover should be enough to take care of annual expenses in your absence, without undue risk. We can look at this through an example.
If your monthly expense is Rs 50,000, then you must be able to earn that much by investing the corpus in risk free liquid funds. This translates into Rs 600,000 per annum. Assuming you will earn 5% post tax on liquid funds, you will need an investment corpus of Rs1.20cr. That is the size of life cover you need. Now, you come to the investment part Why do insurance and emergency funds rank above investments in your financial planning priority list. An emergency fund is essential to ensure that your investment portfolio is not disturbed for your emergency needs. It is like insurance for your investments. But, why insurance? Clearly, having adequate insurance gives you the leeway to take on more risk. The thumb rule is that investors must take on more risk of equities at a younger age. When you and your family are adequately insured, you can realize your full risk appetite. Ideally, financial planning is best done with mutual funds, which are flexible and professionally managed. The first step is to define your goals like retirement, nest egg, children’s education, home loan margin, car loan margin, foreign holiday, etc. The next step is to classify goals into short term, medium term and long term goals.
Then you fit your investments depending on the time frame of goals. Short term goals maturing in 1-3 years are normally matched with liquid or short duration funds. Medium term goals maturing in 3-7 years are matched with debt funds, MIPs or balanced funds as there is the leeway to take on higher risk. Finally, the long term goals maturing beyond 7 years are normally matched with equity funds. Insurance and investments are fluid in nature Once the allocation is done, they continue to be fluid. For example, the total insurance cover has to keep changing with changing income and living standards. The investment mix is biased in favour of equities in the early years but gradually shifts towards debt as milestones approach. That, in a way, is the crux of financial planning as a continuous process.