Thursday, May 6, 2010

Financial Planning - Simplified to 4 Variables

Before I begin today's post, I would like to highlight that my first posting at CPF's IM$avvy site should be up by tonight. Do check it out over at the CPF $avvy Blog Corner under the month of May Archives. The title of that post is "Can You Trust Your Financial Planner?"

Financial planning can be too confusing at times. There are lots of terms that people throw around to make it seem complex.

I was thinking about it for sometime and decided that there are perhaps only 4 variables or factors that will ultimately determine whether one is financially secure.

The 4 Factors

1. Income

Income determines how much money flows INTO your pockets each month or every year. Income involves both active income (from one's salary) and passive income (from dividends, etc).

2. Expenditure

Expenditure is the amount one spends every month. It is the amount of money that flows out of your pockets to buy food, transportation costs, movie tickets, housing installments, etc.

3. Savings/Investments

Savings/Investments should be the difference between Income and Expenditure. Ideally, it should work out as:

SAVINGS = INCOME - EXPENDITURE

From the simple equation above, I guess you can see that the only way to increase your savings/investments is to either increase your income and/or decrease your expenditure.

Another thing to note is that saving money is actually quite meaningless unless you know what you are saving for. Are you saving for retirement or saving up for a holiday? In either case, you need to know that there will come a day when you are going to spend your savings. The timeframe is important so that you know whether you should keep your savings liquid or you can afford to keep them in not so liquid instruments. The end goal of savings should not be just for the hidden pleasure of seeing your bank account grow fat.

4. Savings/Investment returns

This last factor determines the rate of return your savings or investment is giving you. If you are getting a 0% rate of return, the amount of money you save will be the amount of money you have at the end of the day. On the other hand, if you have chosen to invest it and the investment gives you 10% returns annually, the amount of money that you have at the end of the day will be much more than the absolute amount you have actually saved.

Conclusion

In this posting, I have simplified financial planning into 4 simple variables that you need to take note off.

Determine what is your monthly income, expenditure, savings and the rate of return you are getting on your savings. To improve your financial situation, you just need to tweak any of these 4 variables.

I shall cover this in my next posting.

10 comments:

  1. You have seriously overlook the Protection part. Goodness. Go and revise it and don't mislead the masses since you are now at IMSavvy.

    ReplyDelete
  2. Do we consider insurance premium for H&S, Critial Illnesses, PA and Life protection as saving/investment or expenses?

    ReplyDelete
  3. hi axt,

    I classified all premiums as liabilities (expenses) and outstanding cash value from policies if any as assets

    ReplyDelete
  4. Hi CW8888,

    Thanks for highlighting it. I initially put in the insurance portion but left it out on purpose.

    There are a whole host of other things that can be put in too like will writing, etc which I have left out as I wanted to just present a simple concept of financial planning.

    Reason being this:
    Insurance is used to protect the first variable (income) and the third variable (savings). Any insurance we buy is to hedge against the potential loss of future income or hedge against our lack of savings to pay for hefty medical bills.

    That is the purpose of insurance and should not alter the 4 variables that I have tried to simplified here. Just like we should look for ways to increase our income, we should also look for ways to protect our income. Hope you get the drift =)

    ReplyDelete
  5. It is the investment and protection part that most people needs good financial advices on how to meet financial goals and retirement needs.

    Any financial planning without the protection part is like a three-legged horse and beware it will tumble soon.

    ReplyDelete
  6. Hi Axt,

    For H&S, critical illness, PA and life protection, I usually consider them as expenses.

    H&S, CI and PA plans usually do not have any cash surrender value. So you can safely consider them as expenses.

    For whole life protection, the reason why you buy the plan is mainly for life protection. I will consider it as an expense.

    That is just my personal preference though some people might like to treat it as savings. If they treat it as savings, it means that they intend to surrender the policy some time in the future (perhaps when they are 60?)

    ReplyDelete
  7. Hi CW8888,

    Yes. Thanks for pointing that out.

    Insurance or protection is indeed a very important aspect of financial planning. People do indeed need to know the options that are available to help them protect the potential loss of future income due to death, disability or critical illnesses.

    ReplyDelete
  8. Hmm, axt asked an interesting question. I treat insurance premiums as expenses and the net surrender value of policies as assets. I do not treat insurance as investment at all (I only have whole life - the only policy that has cash value) as I've no intention to cash out unless I've no choice :)

    ReplyDelete
  9. Hi All,

    I have asked this question to many people and I have divided answer. And if you will to ask an insurance agent, most will said it is saving/investment.

    IMHO, I think it all depends on the type of insurance policy you are talking about. Maybe there is no right or wrong answer? Being conservative, I treated all of them as expenses, including policy with surrender value.

    Maybe we should pose this question to Tan KL's blog. Will be interesting to hear what he said.

    ReplyDelete
  10. Hi axt,

    Good practice to over-estimate expenses or liabilities and under-value assets. I do that too.

    ReplyDelete

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