Give purpose to your investingAugust 2, 2022
All About Your Pyramid of Personal Finance
It’s been 3 years of working and earning the income you want. You have a lifestyle to follow, an excellent circle of friends, an excellent job, and a string of small luxury items you thought were only a dream until a few years ago. Life is running smoothly, until… one day it is not! You meet an unexpected financial crunch, and your finances have come crashing down. You need emergency funds to aid a medical or a family emergency. The amount is reasonably large, and you do not know what to do. Suddenly your bank balance and goal setting have gone for a toss. It pinches unlike anything else. Right? While you have lived a decent life so far, there is a crucial missing piece in your jigsaw puzzle you forgot to add.
And that crucial element is managing your finance
You must have heard of Maslow’s Hierarchy of Needs, right? It is a motivational theory in psychology highlighting the essential elements of human needs. Similar to Maslow’s Hierarchy of Needs, personal finance consists of specific elements that help you prioritize spending, saving, and investing money without overwhelming your present and disturbing your future. A personal finance pyramid is nothing but a system of creating wealth for yourself. You could do so by investing in diverse assets, saving for emergencies, aligning your long-term financial goals with your current earnings, and managing risks. To help you understand it better, let us look at the personal finance pyramid below.
Importance of personal finance
Personal finance is unique to every individual. The foundation of your financial decisions will have long-term consequences. When securing your financial freedom, you must aim high and dream big. You can achieve your financial goals by investing and spending patiently without disturbing your regular monthly expenditure. Most of us worry about responsibilities creeping in as we start earning. So, what do we do with our money? Should we keep it in our bank without a plan? Or should we invest it wisely across different asset classes? Setting financial goals and managing money from the time you start earning can eliminate several uncertainties and help you make better financial decisions. Financial planning is not as difficult as we make it to be. What matters is our framework and how we move up the financial pyramid based on our priorities and goals.
Let’s take a small case study- Nitish has got a good job in an MNC, and he wishes to start saving for his future. While he understands the basics of investments, he is still not aware of all the elements involved in making a sound decision. He makes his investments most of the time by listening to advice from his friends or peer group. This has led him to make a few safe investments in mutual funds, bank fixed deposits, and the national pension scheme (NPS).
As a rule of thumb, he has avoided speculation at the beginning of his investment journey and concentrated more on how he can save his current income safely. He prefers to make defensive investments than aggressive ones because he lacks proper investment structure and does not have a sound Mutual Fund Distributor (MFD) or Registered Investment Advisor (RIA) to guide him in making those decisions.
As we grow, our personal financial goals also grow. This is where a personal finance pyramid helps us prioritize our investment goals, how to invest, where to invest, and what we can achieve from those investments.
Let us take a closer look at the pyramid of personal finance
The Pandemic was our biggest eye-opener. It made us realize the importance of having an emergency fund. An emergency or contingency fund means keeping a certain percentage of your monthly salary in an account that you will not touch. It is advisable to have at least 6 months’ salary as an emergency fund to ensure some peace of mind. There could be times of high unaccounted expenditure when you may need to use your emergency funds or savings to take care of uncertainties. A difficulty could be a job loss, a medical emergency, or an urgent loan clearance. Having 6 to 9 months of an emergency fund will smoothly help you sail through these tough times.
Suppose your salary is ₹25,000 per month and you have just begun your career. You can start investing a minimum of ₹3000 per month in Debt Mutual Funds such as liquid, ultra-short, short term, or arbitrage funds that do not have a lock-in period and have a good tax advantage in certain cases. It means you can withdraw your funds in case of any emergency.Thus, it is wise to start saving for an emergency from the month you start earning your first salary. Start small and gradually increase your amount so that tomorrow if you must take a break or face an emergency, you will have the funds to help you.
Remember, our grandmothers always had a Gullak (moneybox) at home for emergencies. There was always a little leftover amount every day deposited in that moneybox. That was their way of creating an emergency fund.
Note: On average, the rate of returns on liquid mutual funds ranges keeps changing. The return from liquid mutual funds will be higher than the savings account interest rate offered by a PSU bank or a well-established private sector bank.
Insurance or wealth protection
Having insurance is extremely crucial today. If you are looking at protecting your family, assets/property, and yourself from any financial losses or risks, insurance is one of the safest ways to ensure this eventuality. You can buy different insurance plans, such as health insurance, life insurance, auto insurance, and home insurance. Insurance plans are a way to protect your hard-earned money from any uncertainties.
For example, in case of the untimely death of the sole earning member of a family, term insurance can help in repaying a home loan and help the family survive for a while, depending on the sum invested. Health insurance can help cover hospitalization expenses and medical bills depending on the limit of the sum insured. Insurance plans can help you fund your kids’ education or provide coverage for all your expenditures in case of a policyholder’s death/accidental/medical emergency. In short, it helps to protect your hard-earned money.
After you have your first two steps in place, you will have to diversify your portfolio and invest in different assets to increase your wealth. Creating wealth is not a short-term event but a long-term goal. You can do so by investing in sovereign gold bonds, investing in the stock market, buying equity mutual funds, purchasing real estate, or investing in long-term bonds. Consider your unique profile and preferences before building your wealth. Your investments must align with your asset allocation that suits your risk appetite.
For example, suppose you are a conservative investor. You can consider investing around 20% to 25% of your income in equities and around 75% to 80% in fixed income products, such as government or corporate bonds, post office savings schemes, and exchange-traded funds (ETFs), company deposits, etc. Each investment reaps the rewards in the long run based on the amount you have invested in different assets.
Wealth creation is all about patience and discipline. You cannot expect immediate returns from any investment during this stage. It is beneficial to take guidance from an experienced RIA (Registered Investment Advisor) or a qualified MFD (Mutual Fund Distributor). They understand the functioning of financial planning better than most of the people. They have undergone several financial cycles and can help manage financial behavior, identify your goals, and suggest investment products accordingly. Having a MFD or RIA will help you mitigate the risks you may face while planning your finances. They reduce your chances of investing in stocks or funds not matching your risk appetite, making investing a thoughtful process.
While it is great to stay in the present and target financial freedom as you grow in life, you may also want to consider having a wealth distribution plan. The ideal time you start planning for wealth distribution is when you are reaching 45 to 50 years of age. But having knowledge of how to do that and the steps to achieve it, always helps.
You are taking the necessary steps to grow and preserve your wealth, investing in a portfolio of diversified funds, and ensuring you have enough until you retire. But what comes next? Having a strategic approach to distributing wealth will ensure you do not face any financial crunch in times of emergency or when you have decided to retire. It will help ensure an equitable income flow that will allow you to lead a comfortable life.
No two investors are the same, and you will have your expectations and circumstances. A good MFD or RIA will help you address your financial goals and aspirations and turn your life into numbers that work for you.
Key Take aways
Did you know a monthly saving of around 10k for 20 years (Rs. 24 Lakhs overall) can create around 1 crore at a conservative 12% annualized return. But delaying your investment every year will reduce your wealth creation opportunity and reduce the effect of compounding over time.
There is always a way to manage your finances only if you begin today. We often emphasize not having enough money to do what we want to without realizing that small portions of your income will aid in leading a comfortable life in the future. We must start purposeful investing and working towards a personal finance pyramid as soon as we start earning to reap the effect of compounding and generate greater wealth later in life.
Every step of the pyramid of personal finance is crucial in securing a peaceful state of mind and systematically building your future. Each stage serves to move up the financial planning ladder and achieve your financial goals. Personal finance is a must for everyone, whether a working employee or a self-employed individual, built with resilience, patience, and discipline, not with greed and fear.