If you want to get your finances organized then you must start off with a proper financial plan. A financial plan is a systematic method of assessing your goals, assessing your resources, projecting your inflows and then squeezing corners to meet the gap. If that sounds too simplistic, it is not! The process of financial planning is quite complex and calls for an interplay of goals, investments, returns and risk. Let us understand the common financial planning mistakes. These are the financial mistakes to avoid as they can be detrimental to your long term wealth creation. Let us understand what mistakes to avoid and how to avoid financial planning mistakes..
Delaying the start of your financial planning
Financial planning is all about making time work in your favour. The longer you invest, the more your principal earns returns and therefore the more your returns earn further returns. In technical jargon it is called the power of compounding. Starting your financial plan 5 years late can make a big difference to our eventual corpus and your monthly outlays required. When you start early, you start accumulating a corpus early and that gives you greater leeway to make appropriate changes to your plan as you go along. If you start too late, you simply lose that flexibility.
Focusing on endowments instead of term insurance
Your insurance sales agent is very keen to sell you an endowment policy and he sells it to you as a combination of insurance and investment. You must not buy that idea. Remember, your insurance needs and your investment needs must be kept separate. When you insure be willing to write off the premium. So prefer term plans to the extent possible. On the other hand, instead of getting stuck in endowments, invest the premium saved in mutual funds.
Going for inadequate insurance cover
This typically applies to life cover and health cover. How do you decide your life cover? Take an example. If your monthly expense is Rs.75,000, then your family will still require that amount on a monthly basis in your absence. To earn Rs.75,000 per month you need to earn Rs.9 lakhs per year. You cannot take the risk of volatility and illiquidity so it is best you are invested in liquid funds. Liquid funds give you 6% returns on an average so your family will need a corpus of Rs.1.50 crore on hand. Then there are liabilities that need to be closed so you must be looking at a term cover of at least Rs.2 crore. Similarly, in health insurance it is fine to take Rs.5 lakh cover for each member but if you are taking a family floater, then let it be higher.
Not saving enough at an early stage
To invest you first need to save money. The mistake most people make is to treat savings as a residual item after spending to one’s heart content. Actually it should be the other way round. Expenditure should be a residual item after meeting your savings target. Try doing it that way and you will be surprised to see how much you save at an early age.
Not taking enough risk when you can afford it
AT the end of the day returns are always a trade-off against risk. If you want to create a corpus over 25-30 years then it is ridiculous to be predominantly invested in debt. Over such long periods, equity funds have given great returns with negligible risk. Your risk need to be calibrated. When you can actually afford to take risk, you have to take calculated risks. Otherwise, you are never going to create wealth through debt alone.
Ignoring the impact of inflation in financial planning
Inflation is considered to be the thief of value, and not without reason. When inflation is 8% then Rs.108 that you will receive after 1 year will only be worth Rs.100 today. That means, your monthly SIP must be growing at least above the rate of inflation. If the annual inflation is 6% then your annual accretion to SIPs must be at least going up by 10% each year. Otherwise you will never be able to beat inflation.
Wasting too much money servicing your debt
If you have money and you have a lot of high cost debt like credit cards and personal loans, then what should you do. The answer is simple! Just focus on repaying your high cost loans first. You pay 37% annual interest on your credit. When you close your credit you are virtually earning 37% annually. There really cannot be a better investment. Use intermittent cash flows judiciously to repay debt. You will also save yourself from financial risk.
Choosing dividend plans instead of growth plans
This is a cardinal blunder a lot of people commit. When you invest in MF growth plans the compounding takes place automatically. On the other hand, if you opt for dividend plans then you have to reinvest the dividends received. That never happens in practice and therefore it impacts your final wealth count. Ideally prefer growth plans as they are all about automatic compounding of wealth.
Ignoring the impact of taxes
Taxes make a big difference to your effective returns. When you earn dividends or capital gains there is a 10% tax under specific conditions. However, if you earn interest on bonds then the returns are taxable at your peak rate. When you chart out your plan always look at its effectiveness in post tax terms.
Creating and running number of parallel plans
Finally, we all make the mistakes of parallel plans. There is a college plan, a financial plan, a tax plan etc. That is not the right way. Have one master financial plan. Everything else just becomes a subset of the master financial plan. That is the way it should be!