personal finance guide for Long-Term Success by Taking Control of Your Finances

As the new year begins, assessing your personal finances should be at the top of your list. Much of the advice on this subject tends to focus on investment opportunities, which always irks me for some reason. It’s my firm belief that “personal” must come before “finance”, and that our individual circumstances are more important than any financial gain.

No financial plan can be completely effective without taking into account the particulars of your lifestyle. This post will shed light on the essential elements that must be incorporated when attending to your personal finances. Since each person’s circumstances are unique in some way, it’s impossible to cover everything.

This post is for everyone, regardless of whether you have begun your personal finance journey or not. The financial review process for retired individuals varies from the rest, and I’m hoping to cover that in a later post.

 – Don’t be scared

We know that money is an uncertain endeavour and we are programmed to have a distaste for it. Research found that not knowing what could occur can be even more stressful than if we were aware of something bad happening without fail. We also experience a great sense of loss when something is taken away, which is known as loss aversion, but there’s more to the picture. Even in cases with unknown outcomes, people would rather stick with the known; this tendency is called ambiguity aversion.

But why do we hate uncertainty?  

The research suggests that when you lose money, the same areas of your brain are activated as when you experience physical pain. The sensation of financial loss could be likened to a blow to the face.

When looking over your financial situation, you must make difficult choices whose repercussions might not become evident for years. It is quite natural for us to want to dodge this uncertainty by doing nothing or taking the simplest way out. I’m not suggesting that you disregard this fear; rather, stay conscious of how it can lead us astray.

For new investors

People tend to shiver at the thought of taking care of their financials due to the fear of making a mistake. Questions such as ‘What if’ or ‘Will I lose money?’ often hinder them from getting started. However, one must understand that making errors are inevitable and part of the learning process. Nonetheless, not managing your money is a far worse judgement than any other.

Taking care of finances is no exception to challenges in life. The initial step can be daunting, but with practice and patience things will become more manageable.

Making big financial choices can be scary, no one expects you to be immune. However, not making decisions out of fear can make all the difference between a satisfactory retirement and a dismal one. Maybe your response is, “Nicely put, but what do I do to handle this dread of uncertainty?” The rest of this article supplies an answer.

 – A time for reflection

Alfred Korzybski was a Polish scholar who first used the phrase “the map is not the territory”. It implies that what we assume about a situation is far from reality. This same concept applies to personal finance where our projections are distinct from the actual outcome. Life does not always go according to plan and we have no choice but to deal with whatever comes our way.

Personal finance has become overly focused on product purchases, but it’s important to remember that the products we buy are merely a means to an end. We should take the time to review our financial situation and consider our life circumstances.

What does this mean?

A year can certainly pass quickly, and many things can happen. Consider all the changes in your life since this time last year; major life events can have a profound effect on your finances. Knowing this broader perspective of your life makes it simpler to take action.

In the last three years, we’ve seen a pandemic that has affected our way of life, an inflation spike causing higher living costs, and a gloomy economic setting leading to pay cuts and unemployment. Furthermore, you may have gone through personal changes like marriage or welcoming a baby into the world – or experienced hardships such as job losses or business failures – which all can take a toll on your finances.

When it comes to money, we don’t often talk about it with our loved ones. Unfortunately, this can lead to surprise financial blows since we haven’t been forthright with one another. It’s not just about ourselves when it comes to personal finance; the well-being of those close to us is also a factor.

Elderly people, such as your parents, are particularly at risk of becoming victims of financial fraud and mis-selling. Unfortunately, they often don’t discuss their finances with their children, so if they have been tricked or purchased a poor product, the consequences can go unnoticed for an extended period of time. In fact, there are countless instances where elderly people have lost their pension pots due to this type of deception.

Having a holistic view of you and your dependents is important.

For new investors

New investors should be aware of their finances before making any investment decisions. Money discussions can be difficult to bring up, but it’s important to have them. Evaluate your financial situation and you’ll be ready to decide on where to invest and what product is best for you.

– Know where your finances are

The next step is to take a financial inventory and figure out your net worth.

Why?

Figuring out your financial health is like getting a full body health checkup, and it’s the bare minimum you can do annually. To do this, calculate your net worth – assets minus liabilities. To get an accurate reading of your finances, however, looking at cash flows is essential. It doesn’t have to be as overwhelming as it sounds – simply look at aggregate inflows and outflows every month.

Gathering details can be a hassle, but banking apps often offer rudimentary budgeting tools. To make it simpler, you may want to take advantage of other personal finance applications or use a spreadsheet. Checking out Morningstar’s template guide could provide a great starting point.

Given that many banks now belong to the infrastructure of account aggregation, we should expect a greater variety of personal finance tools in the future.

By tracking your cash flows, you can identify areas of increasing expenses and thereby minimise unnecessary spending. The greatest advantage of this is that it can help you dodge lifestyle creep or inflation; something that detrimentally affects retirement readiness if your saving rate remains intact while expenditure rises.

After analysing your cash flows, creating a personal balance sheet, or net worth statement is the next step. This provides you with a benchmark for understanding the state of your financial situation. By tracking its changes over time, it becomes easier to recognize any issues that need addressing and then take action to make necessary alterations for improving your finances.

Create a document that keeps track of your assets and liabilities

Assets 

o   Cash balances in all your bank accounts. 

o   Investments across fixed deposits, stocks, mutual funds, bonds, insurance, pensions, annuities, chit funds, Govt savings schemes, etc.   

o   A realistic value if you own a house, jewellery, art, etc. Estimating the values of illiquid assets like houses can be hard, but you can use a reasonable guesstimate based on similar properties, online sales data, or other prices. It’s better to be conservative when estimating.    

o   Other assets 

Liabilities 

o   Housing loan balances 

o   Loan balances for all other loans like car loans, personal loans, buy now pay later (BNPL), loans against securities, loans against insurance, jewellery, etc.  

o   Other loans and liabilities 

A spreadsheet can be used to determine your net worth; that is, the total of your possessions minus any debts you have. 

If you don’t have a handle on your net worth, then managing your money is like trying to find a target in the dark.

Consolidate whatever you can

Examining your financial situation can assist in ascertaining whether your money is scattered over various avenues. Consolidating your funds will make managing easier. Utilising a Zerodha account or any other trading platform for investing in mutual funds, for instance, doesn’t hold much value when you already have it. The back-office conveniently provides all the information related to you and your family with just a few clicks.

o   If you are married, involve your partner when reviewing your finances.

o   If your parents are taking care of their own finances, you should encourage them to review their finances. If you are taking care of their finances, review them and ensure your parents are financially set.

o   If you have more than one account with different brokers, banks, and platforms, it’s best to close any that you don’t require.

o   If you have any toxic products, such as endowment policies, traditional insurance policies or ULIPS, it’s wise to get rid of them. These products come with hefty costs and little financial transparency, doing nothing but making the insurance companies wealthy while leaving you with less money in your pocket.

Reviewing all your finances can be a clarifying exercise because it forces you to think about all aspects of your life.

 – Review your goals

Once you have a good understanding of your financial situation, the next phase is to evaluate your fiscal objectives.

In finance, when it comes to goal setting, there is much debate. Some feel that having a set of goals is essential in terms of being realistic and striving for tangible results, while others counter that our objectives are often unknown or subject to change. They go on to further caution that when very specific goals are set, they can lead to distorted risk-taking, tunnel vision, a lack of consideration of the bigger picture, and even bad decisions once an aim has been achieved.

As usual, the truth is likely somewhere between two extremes. We tend to think about things in terms of goals, for instance when you get your pay cheque at the end of the month you mentally set aside money for different expenses like rent, savings and shopping. This process is called mental accounting and was created by Nobel Prize winner Richard Thaler. Goals-based investing takes advantage of this innate inclination.

Focusing on results is an uncertain pursuit, and our objectives are often ambiguous. Even if we can identify them at the outset, our plans for the future may evolve over time. For instance, if you plan to purchase a home after five years, by that point you may have adjusted your preferences as to size and location.

Morningstar carried out a survey, posing the question: what are your top 3 objectives? After displaying a general list of financial ambitions, 73% of respondents altered at least one of their prior three.

I’m a fan of possibilities planning, which involves first identifying what is attainable and then setting goals. This strategy appeals to me because it has more room for movement. The majority of fiscal plans don’t succeed due to their rigidness – disregarding the fact that life is ever-changing and necessitates adaptations. It’s eerily similar to that saying, “Man proposes, God disposes.”

There’s no single best way to manage your finances. Some individuals save indiscriminately, others have vague targets, and still other people have concrete objectives. Ultimately, everybody needs to discover a strategy that works for them and stick with it. Instead of being particular, focus on creating effective systems. You can only affect the processes; the results, however, are out of your hands.

How to review your goals?

A few things to remember if you have goals: 

o   Goals should be well-defined. For example, I want to retire in 2065 with 10 crores and withdraw 4% every year.  

o   Estimate the cost of the goal.

o   Calculate the amount you need to save and adjust it for inflation. The SEBI website has useful calculators to help you plan.  

o   Figure out the right asset allocation for each goal with reasonable return assumptions. Here’s an example:

A few things to keep in mind

Take a peek at the return assumption listed in the footer of the above image. Believing that a 50/50 equity-debt portfolio will provide 12% and a 75/25 one 14% is asking for trouble – remember just because Nifty has given an average of 12% in the past doesn’t mean you have to assume that rate when doing your own projections.

You should mix your investments between equity, debt and gold for long-term goals like retirement. This way you can keep your equity exposure in check as you get closer to retirement. Your returns won’t be as high as 15%, but making a realistic assumption is important. Of course, if you end up getting higher returns it’s an added bonus.

For shorter-term goals, under 5 years, use a savings bank, FD, or liquid fund returns. 

Know the difference between risk tolerance and risk capacity.  

o   Risk tolerance is your ability to withstand market volatility.  

o   Risk capacity is how much risk you can take at a goal level. 

Take the example of a 30-year-old who is looking to retire at 60. Since the timeline is quite long, they should be willing to accept greater risks by investing heavily in equities, possibly as much as 70%, with an accompanying 30% in debt options.

Let’s say you’re looking to buy a house in seven years and have an aggressive investment attitude. You are not worried about market fluctuations, but that doesn’t mean taking on more risks is a prudent decision. Since your goal has a short timeframe, the associated risk capacity is quite low. By investing 60% of your funds in equities for this objective, you’ll leave yourself open to sequence risk – if the market drops 50% in the sixth year, it will potentially hinder your attempt at achieving this goal.

Aligning your goals with your values

An issue when it comes to fixing our goals is thinking about the aspects that are meaningful and important to us. It might not be immediately merited, but we have an instinctual feel for figuring out what matters most in our lives. We strive to make progress in the direction of these goals without being fully aware of it.

When taking a look at your goals, lean into this. Personal finance may not be a maths problem, but it is most definitely a people problem. Delve into the things that matter to you and determine what your values are; in doing so you will begin to see how your values shape your goals. Ask yourself difficult questions – doing this on your own or with the help of a financial advisor – is the key to success.

I love George Kinder’s three questions for financial planning.  

Question 1: Design Your Life

Think of yourself with ample financial security. Envision how you’d live and what you’d do with the abundance. Permit yourself to enjoy all that it can bring: permit yourself to dream without limits. Describe an existence which is thorough and yours to the fullest.

Question 2: You Have Less Time

Your doctor has given you a limited time frame to work with: five to ten years. On the one hand, this means you won’t suffer any sickness in that time. However, the flip side is you won’t know when your death will occur. How will you make the most of what’s left? Will you take steps to alter your life? If so, what will they be?

Question 3: Today’s the Day

Your doctor delivers the startling news that you have merely 24 hours remaining. Ask what feelings surface as you confront the reality of your mortality. What unrealized dreams will remain? Are there any things you wish to have accomplished but have not? Is there anything else which must be addressed before imminent demise?

George is the originator of financial life planning and formulated these queries to prompt people to contemplate their priorities. Noticing that each one leads to more profound reflection, they can also stir up intense feelings like shame, regret and grief. But processing such emotions can help to pursue those aspirations that are most significant and bring purpose.

– Debt

Good debt management is an essential part of personal finance. Even the most successful investors, like Warren Buffett, can be ruined if they don’t manage their debt properly.

Be sure to research all your liabilities before making a decision. Unfortunately, some debts have an undeserved bad reputation; not all of them are bad. Without going overboard, loans such as those for housing and reverse mortgages can be beneficial.

If you can acquire all pertinent information about your loans, it should not be a difficult task to determine the source of the problem.

Here’s a broad range of interest rates for major loan categories.

Using a credit card as a loan can be disastrous, as interest rates can reach as high as 42%. It is only beneficial when handled properly by someone knowledgeable of the system; otherwise, it can spell disaster.

Using a lending app to take out a loan can be risky, especially when it comes to housing loans. If the interest rate is high, it could be difficult to make the payments on schedule. It’s still possible to minimise the amount of money spent on interest by paying extra each month. This is because initially most of the EMIs are allocated toward interest as opposed to repaying the principal.

Failing to pay off expensive loans such as credit cards and personal loans is not a wise decision. Before you start saving or investing, your priority should be to pay these financial burdens off. Here are some strategies you can use to do so.

Snowball method

Create a ranking of your loans by outstanding amount, from smallest to largest. Pay the minimum on each loan, with the exception of the first one in your list. Use any remaining funds to pay off that debt and afterwards move on to the next one until all are cleared.

Avalanche method

Create a ranking of all your loans by interest rate, starting with the highest first. Make minimum payments on each loan except the one with the greatest rate. Utilise whatever funds remain to pay off this particular loan. Once you’ve dealt with this one, shift your focus to the originally next in line.

If you’re fortunate enough to have high earnings but are also burdened with debt, it’s senseless not to prioritise paying off your loans. Doing so is akin to gaining a guaranteed return, and the relief of being free of debt cannot be overstated.

Credit score

It’s essential to go over your credit scores every year. Credit bureaus such as Experian, Equifax, TransUnion CIBIL and CRIF Highmark in India keep an eye on your debts and allocate a score from 300-900. The higher the count, the more reliable you look for creditors. You should really try to attain a mark of 750+ or above for optimum credibility.

The credit bureaus offer a free report for downloading from their sites. Yet, an incorrect detail in your report can impact your score. Thus, it is advisable to raise a dispute on the bureau’s website and get it rectified. Other than type, mix and duration of credit; other elements also contribute to the score. To begin with, refrain from taking too many loans and try to pay dues promptly – this is a good starting point. Additionally, here are some more suggestions.

– Insurance

At this point, you may be wondering, why is there no mention of investments? This is a great shame, since personal finance has become barely more than a discussion of investments and products. Before you focus on making gains, it’s vital to play it safe.

Why? 

It should be evident, but I’ll put it plainly here. Let’s say you have a robust savings rate, a competent investment portfolio and nice returns but no emergency fund or insurance. In the case of a medical situation, your investments are your de facto insurance and crisis fund. Sadly, this is the harsh reality many residents of India have to face: one health disaster away from financial calamity. Even middle-income earners often don’t insure themselves, leaving them with no choice but to spend their savings or take on large loans at high interest rates when trouble strikes.

The 2 key types of insurance you need are  

o   If you have dependents, term insurance (life insurance). 

o   Health insurance.

Term insurance 

Having dependents means life insurance is essential. A practical policy that pays out in the event of your passing should cover lost income, as well as factoring in inflation due to rising expenses year on year. Consider if a sum of Rs 1 crore invested in an FD at 7%, with a monthly interest of Rs 57,994, would be sufficient for your family. Pro tip: the bigger the cover, the better!

Health insurance 

I cannot emphasize enough the need for health insurance due to the increasing costs of health care. Paying out-of-pocket is not a feasible option. To secure yourself, it would be best to begin with a base coverage of Rs 10–20 lakhs and then adding an additional top-up policy if necessary. Shrehith from Ditto recently published an enlightening post about selecting appropriate health insurance coverage, as well as a comprehensive module about health insurance – both of which are worth reading.

Review 

o   Check if you have appropriate term insurance cover. Use this guide as a reference. 

o   Check if you have adequate health cover and the right policy. Here are a few things you need to watch out for when picking a health insurance policy.   

o   Do not purchase any insurance plans that combine coverage and investments. These schemes are hazardous and provide the least desirable elements of both components.

Insurance is specific to each individual’s life situation, and seeking advice from an insurance expert is always wise. If you’re looking for guidance with a current policy or are interested in purchasing a new one, ditto can provide the assistance you need.

For newbies 

If you are just starting your personal finance journey, ensure you have adequate insurance cover before you do anything. It’s important to protect both yourself and your dependents.

– Emergency fund

Creating an emergency fund should be the next step in your personal finance plan. Unexpected events such as job loss or the need for house repairs can put a strain on your finances, so being prepared is key. Having this fund available means you don’t have to resort to taking out loans or selling investments in a crisis.

How much should you have as an emergency fund? 

The general rule of thumb is to store 3-12 months’ worth of living expenses for emergency funds. However, those with more job security – such as young people – can have a smaller reserve. Conversely, those who work in contract or high-income roles, or who have less certainty over their employment, should aim to have larger reserves.

Where to park your emergency fund?  

It’s important to make sure your emergency fund is liquid and can be accessed quickly. Stocks are too volatile, so the best option is to place your money in something easily accessible like a liquid mutual fund. Although the returns may be small, the primary purpose of an emergency fund is to give you a safety net – not to generate income.

Liquidity of the emergency fund matters more than the returns.   

A few pointers 

o   The size of your emergency reserve depends on the stability and reliability of both your income and expenditure. The greater certainties that exist, the less money you need to keep in a liquid fund.

o   It’s not necessary to have an emergency fund that equals 5 years of income. Instead, strive for a sensible balance.

o   If you are young, there is no need to have a 6-month emergency fund right away. You can begin with a SIP and gradually build it up, as well as add funds when you get bonuses or large sums of money.

o   Avoid the temptation of seeking high returns with your emergency fund; it’s a mistake you won’t want to make.