Humans have been able to survive as a species due to their ability to adapt to changing conditions. However, amongst humans, those who have excelled more have been those who committed themselves to meticulous planning, discipline, and hard work. They set a goal and try to achieve it. When we think from a financial planning perspective, the consumptive nature of man makes it difficult to save for the future. We might not be able to work for all our lives, particularly when we are old. Hence comes the need to plan savings, spendings, and investing with objectives set beforehand.
These financial goals need to be specific, realistic, and action-oriented. We need to figure out how much money we will need in the next few decades. We must have a budgeting capability to enhance spending and saving. We know we want to have a well-planned retirement or buy a new house or want our children to get educated from world-class institutions. However, these are specific goals, but without action, it will mean nothing. These goals need to be quantified in actual money term and must be assigned a target date.
Once we have specific financial goals, we need to address another critical problem, i.e., how to fund these goals? We need financial discipline here. Most of the millennials live on very little or no savings for future needs. We wait for the month end to get our paychecks and end up spending most of it in the first 20 days of the month. The solution to this problem is proper budgeting and financial planning. We need to be realistic and practical about our needs for at least the next five years, to keep our spending in check. There is no limit on how much we can spend. Instant gratification sure is fun, but it has costs.
Once we have savings in hand, the role of asset allocation kicks in. Saving money does not equate to wealth creation often. Wealth is created when money saved is invested and grown in a planned fashion. The money saved should be invested in appropriate asset classes, depending upon the person’s risk-return profile. Next step would be to figure out how and where to invest. We can buy equities directly using online brokers, get ETFs, mutual funds. Alternatively, we can go for Systematic investment plan (SIP) to make these investments. A specific date of a month/quarter/year is selected to make these SIP investments, providing the benefit of dollar cost averaging.
The disciplined process of investment, along with the right asset allocation, can help in making the best use of the power of compounding. The power of compounding is such that it helps you earn a return over the return. Einstein once called it “the 8th wonder of the world.” Let’s look at an example: Suppose we start investing $100 every month in an equity fund for ten years. Let’s assume that the return generated by this fund is 10%. The saving at the end of ten years will be $20,485, whereas the total amount invested would have been $12,000. Thus, disciplined investment and power of compounding resulted in a gain of $ 8,485.
In essence, we can summarise financial planning as principally three steps:
- Set up the specific and well defined financial goals
- Ascertain the asset allocation that meets your financial goals
- Follow a disciplined investment approach to make the best use of compounding