How to manage personal finances – This is often one of the most thought but seldom actioned aspects in a household. Even finance graduates and accountants who keep a strict vigil over even a rupee spent in the company are often lax when it comes to keeping the personal finances in order

Sure – I know – spend less, save more – that sums it up right?

Actually NO.

While saving is a good thing, it is not everything. So, let’s discuss the correct approach.

How to manage personal finances – why to manage at all?

This question is there because the world is full of people who did not do this and then landed in trouble in the latter part of their life. Even people like Sushil Kumar who won 5Cr in ‘Kaun Banega Crorepati’ land in trouble when they are unable to manage their finances properly.

Hence, there would be little chance for people who don’t have so much money to make do with. So we should always have a plan in place so that we don’t stray too far from what we expect to live like in the future.

So let’s discuss the steps that are required for you to prepare your financial plan

Step 1: List your goals and prioritize them

The foremost step in any plan is to have a goal. Hence even for personal financial plan goals are required. Goals come from aspirations which can be categorized as:

Needs, Wants, and Desires.

Needs are basic requirements to lead a life – Food, clothes, shelter, transportation, etc.

Wants are 1 step higher on the luxury ladder than needs. When the need gets fulfilled, ‘wants’ satisfy an innate requirement of luxury. Example – transportation to the office via some mode is a need; buying a car would be a want.

Desire is another step higher than want. Continuing the above example – desire would be to buy a Ferrari. Generally, desire is something that is not genuinely attainable immediately.

Another important classification of goals is on time horizon :

Short term: Goals that typically need to be fulfilled within a year – Example can be buying clothes, going for a holiday, etc.

Medium-term: Goals that typically need to be fulfilled within 5 years – Example can be buying a car

Long term goals: These are longer-term duration goals – Buying a house, Children’s higher education, retirement planning, etc.

Once you have listed down all the goals you need to prioritize them. This is important because this will define what you spend your income on. Generally, if you can define – needs, wants, and desires – A common rule of thumb would be to prioritize needs over wants and wants over desires.

Step 2: Estimate the money required to fulfill the goals

Everyone knows this because it is so obvious – There is a sum that is required to fulfill my aspiration. However, there are 3 major errors that people make in coming up with numbers

  1. People who don’t put pen to paper – generally underestimate the number of goals that they want to save for – People might think of the very large goals like buying a house, retirement, etc. however they miss out on the smaller and more frequent expenses – like buying a car, holidays, children’s education (yes now good education in India also costs an arm and a leg)
  2. If not properly planned, the degree by which the estimate is off is generally directly proportional to the time duration after which the money is needed. This is because people generally underestimate inflation effects.
    At a 5% inflation – 1L per month spends would be 4.3L spend 30 years down the line. While inflation can go up or down this will give a general idea of how much things can change if the time gap is large.
  3. Even for goals that are taken into consideration (especially retirement)- people might not correctly calculate the amount of money that is required to maintain a lifestyle. People might take a general average which might be way off from the amount required to maintain the lifestyle they want for themselves. They may also not impact certain lifestyle diseases etc which might happen

Hence it is important to put a good deal of thought and research into what kind of lifestyle you want and how much money would be reasonable to provide you that kind of life. Thereafter, it is a good practice to take some buffer on it (for unseen situations) if feasible without making any large scale sacrifices in the present.

Step 3: Plan your expense budget and investment strategy

After you have arrived at the goals that you want to achieve in life and the amount required for those goals you need to then look at the current income and expense calculations. Let’s say you earn 1Lac per month and spend 50,000 per month. Then you have 50,000 per month to save.

Now its time to divide the 50,000 into various buckets which will fuel the various goals. Important factors to keep in mind while doing this are:

  1. Always keep money aside for insurance (Life, health, general) and in an emergency fund. This is very important because while it may seem like a waste of money when nothing bad is happening, a whole life’s worth of planning and saving may become undone if something bad does happen. It is always better to be safe than sorry
  2. Keep in mind the time horizon when the money is required – Longer duration can allow for some strategies which shorter duration won’t. There are many aspects to keep in mind when choosing the right investment strategy which can be found here.
  3. After considering the investment options according to the linked article and also keeping the above points in mind – it may happen that the amount is not sufficient to fulfill all goals. Here, prioritization will kick in. Now prioritization will be 2 types
    1. Whether that goal itself is important or not – Redirecting that money towards fulfilling other more important goals
    2. Whether that goal can be deferred into the future – Even deferring some goals can be a good option as you can get interest income on the money not spent. To decide on which spends are worth it do go over this article.
  4. Hopefully, after the prioritization – the plan would be complete and you would know what goals are you saving for and how much exactly needs to be saved. All you need is now the last step

Step 4: Execution: Saving, Investing & Recalibration

This is one of the most crucial steps in the entire exercise. Without this just asking how to manage personal finances and making plans would do no good. It would just increase stress.

One needs to be very disciplined to follow the plan as detailed in the previous steps. Apart from long term planning, it is also important to learn how to manage personal finances in everyday life – keeping monthly expenses low (not stifling your present wishes totally) can have a huge impact on goal achievement.

One tip which would help in following this is to be a little easy while computing the monthly savings number above – If you take a very high savings number and then make the plan, then any deviation will require recalibration. However, if you are a little easy, you can always save more and then maybe do some discretionary spending when required.

However, even after being disciplined, and having buffers, there might be situations that can arise and disrupt the plan (Stock market crash, CoVid – (how to manage personal finances when out of a job because of a pandemic?), Lower returns than expected, etc. to name a few). In such cases, it is required to again recalibrate the plan and try to do prioritization to find out if we can live without some goals so that the most important ones remain funded.

Apart from the big changes, there might be some smaller changes that keep happening around us which can change the assumptions that we used to make the plan. While these may seem small, they may have a large impact on goals down the line. For example: if we assumed 5% inflation but it has been 6% consistently – it may change the retirement corpus requirement by a significant amount.

This is why is it always imperative to keep an eye on how the portfolio is shaping up and what changes are happening in the assumptions and keep adjusting the model. In case small adjustments make a cumulative large impact – it may be a good idea to try and save more but if it is still not enough then it may be required to reprioritize some goals.

Please do make sure that the savings are not done at the expense of insurance. That would not be termed as savings but as increasing risk.

Conclusion

Financial planning is very important for every family/ individual. While we have seen many people go on with their lives on autopilot without any plans – there are many instances where this approach backfires. There can be 2 types of problems:

Some people go about their lives living in misery, not spending money on their wants (even needs) and then have a lot of money and a life full of regrets at the end.

Others go about enjoying their lives, only to become dependent on others in the latter part of the lives or have to live in abject poverty, reminiscing and cursing the outlandish spending patterns of their past.

Don’t know which situation is worse – in either case, there is a period of life where optimum satisfaction is not achieved.

Hence, everyone should do personal financial planning to achieve the peace of mind and the optimum quality of life (balanced over the entire lifespan) it helps provide.

What are your best practices on how to manage personal finances? Do let me know in the comments if I missed something or if there is something that you would like me to cover in the coming articles.

Categories: Personal Finance

Ravi Maheshwari

Ravi is an IIM ranker with over 9 years of work experience and has helped optimize the financial performance of companies like BPCL, Sun, Ola, Swiggy, and Curefit. In this blog, he explains how to improve personal finance and also gives insights into financial models of companies.

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