All of us need money, and most of us need it more and more. The underlying reason for the entire science of Economics is that resources are always scarce as compared to needs. At the micro level, the same applies to all of us albeit in differing proportions. At the basic level, even the poorest need money to survive. And at the highest level even the rich want to earn more to fulfil some pending objectives. The amusing part is that very few actually measure their requirement. And in what time frame would that amount be required. What is immediate always gets our attention, but the distant requirements remain a vague acknowledgment. So, in fact, most of us are always planning only for the immediate financial objectives. And this is generally done at the cost of what is away, and probably more critical.
For a healthy financial life, it is important that you are always in control of your financial needs. You need to avoid coming under any form of financial distress. This does not mean that you will be able to get everything that you desire. But you may be able to minimize the mismatch between capabilities and desires. This is possible by having realistic objectives which can be attained with existing/possible/probable cash flows with reasonable assurance.
Articulating Financial Objectives
The first step in the process of measurement is to articulate the financial objectives. We all need to sustain a self-defined respectable quality of life which entails some routine and discretionary expenses. Apart from sustaining this quality of life, one has many objectives through his life time. At the basic level, objectives need to be stated along with some idea of likely timeframe. Some of the prominent ones are as under: –
(a) Higher education child in the Yr 2025
(b) Marriage of child in 2032.
(c) Residential House by 2023.
(d) Retirement Corpus by 2035.
(e) Purchase of Car every 10 yrs starting 2021.
(f) Foreign vacation every 3 yrs starting 2035.
(g) Philanthropy by 2055.
A broad diagrammatic representation would be as under: –
Calculating Time value of Money
We all understand that money has a time value. This value has two dimensions, one which increases and another which decreases. The money invested today will grow in absolute amount over time due to effect of compounding. At the same time the purchasing power of money will decrease over time due to inflation. The differential between these two aspects will provide us with the real growth of money over time. This could either be positive or negative. The values and calculations which are relevant and important in this context are: –
(a) Present Cost. This is the present cost of the financial objective if you had to execute it today.
(b) Future Cost. This is the future value of the present cost at the desired date factoring the inflation applicable to the nature of expense. Long term inflation of various expenses like real estate, education, automobile, travel etc may be different from the general WPI (Wholesale Price Index) and CPI (Consumer Price Index).
(c) Present Investment. This is the present value of investments in different asset classes.
(d) Future Value of Investment. This is the likely future value of investment on any desired date based on the probable rate of return applicable to the respective asset class. The long term probable rates of returns from different asset classes are different.
Example
Let us try to understand the same with a simple example. The moment one starts earning, the aspirations and financial requirements also start taking root. If Mr Gupta gets a job and wants to buy a car, than that becomes his first financial objective. Assuming that the monthly income of Mr Gupta is Rs 50,000/- and his monthly expenses are about 25,000/- ; keeping some additional amount for discretionary requirements he might be able to save about 15,000/- per month. If he earmarks the entire saving towards purchase of car and makes a recurring deposit which gives him interest at the rate of 5%, he would take 36 months to accumulate Rs 5 lakh. But by this time the cost of car would have also gone up. If we take inflation of automobiles at 8%, the car might now cost about Rs 6,35,000/-.
So, the corpus is still short of requirement. Mr Gupta has three options: (a) defer his plan to buy car for another 6 months by which time the accumulated corpus and the cost of car would be equal to about Rs 6,50,000/- (b) Increase the savings per month to Rs 16400/- so that the corpus after 36 months is Rs 6,35,000/- , or (c) Invest RS 15,000/- per month in an instrument which gives about 11% return so that it accumulates to Rs 6,35,000/- in 36 months.
Basically, he will have to arrive at a suitable amount of saving to be employed in an financial instrument with desired probable rate of return. The objective being accumulation of the target corpus in the defined time frame. We have also discussed in another article : Monetary & Lifestyle Inflation : The Killer Combo, that it is difficult to reverse lifestyle inflation. Therefore, he needs to start planning for the second car soon after the present car’s life cycle is over. Buying a Car becomes a recurring financial objective.
The Easier but Wrong Option
The above example seems easy to understand but is actually very difficult to follow. Most people find the easy way out by funding existing financial requirement through Debt. That increases the cost of objective significantly. For eg if Mr Gupta plans to take a car loan at 9 % to buy the car today itself and pay back the loan over next 5 yrs, the actual cost of car in todays value would be Rs 5,50,000/-. This is about 10% more than the actual value.
As one would be paying off credit, there will be little to save for the next car. And generally one ends up taking a 2nd car loan even before full repayment of the previous loan. All this happens at the cost of other important objectives and has the potential to cause financial distress. Debt should be used to fund expenses only when the cost is less than the opportunity cost. As discussed in the article You have Idle Cash – Should You Pay off the Loan ?, these are mostly those loans which qualify for some tax rebate, like home loan, and in some cases education.
Assessing Present Position
To be able to formulate a workable plan encompassing all financial objectives, it is important to correctly assess the present position. This includes the following: –
(a) Present Assets (eg property, investments in equity, debt and savings etc) and liabilities (eg loans etc).
(b) Present and future (to the extent predictable) Income Levels.
(c) Time to finally retire.
(d) Present Expenses.
(e) Present savings Capability.
Matching Capability with Aspirations
After assessing the present accumulated and recurring savings, one can start matching the future value of these assets with the future costs of various financial objectives. This process might lead to following: –
(a) Highlight some gaps suggesting change in the investment plan.
(b) Highlight sufficiency to indicate staying on course.
(c) Highlight wide gaps indicating requirement to tone down the aspirations, or defer the objectives (if possible), or implement changes to existing lifestyle freeing more cash towards investments.
(d) Highlight adequate surplus after meeting all objectives, suggesting including more objectives or further improvement in quality of life.
Preparing Investment Plan to Achieve Financial Objectives
Having gone through the above-mentioned process, one can formulate a workable financial/investment plan and implement it. The plan can subsequently play out favorably or need some course correction and therefore a periodic review is necessary. The plan once prepared remains a base/benchmark which has to be revisited frequently. This has to be done on account of many happenings in personal life which have a financial bearing.
Importance of Time
It is now well understood that time has a major impact on everything. Most of us delay and defer the planning for important objectives. We subsequently end up with some major compromises when the further deferment of essential expenses becomes impossible. Own retirement planning is one such important objective which gets the least attention and funding.
Conclusion
There are instances in where we see a person with high net worth living poor, and may be vice versa. Money is a means and not the end by itself. Money serves its purpose only when spent for the intended objectives. It is therefore necessary that the purpose be identified and quantified, rather than working aimlessly to accumulate wealth without any objective. The overall objective being to be able to earn enough for a decent quality of life, and being able to meet all family/social obligations. If one is able to accumulate more than his/her needs, than distribution to society through various philanthropic options can be considered.