What will it take to gain financial control? Consider the structure of your house: the foundation, the frame, the roof and the siding. What would happen if one of these pieces was missing? Now imagine your financial picture is also made up of four equally important parts.
We call these the four cornerstones:
•Cash and liabilities •Protection •Investments •Taxes Together, these four cornerstones reinforce your financial foundation so you have more power to persevere through difficult market conditions. But without any one of these cornerstones, your financial foundation is less stable and could be more vulnerable to challenges that may lie ahead. By focusing on building the four cornerstones into your financial plan, you can establish a strong financial core, which can help you progress toward your future goals and protect you from setbacks along the way.
Cornerstone #1: Starting with the basics – cash and liabilities
What you do with your income is central to your overall plan. And here’s one basic rule that applies to everyone: What you bring in must exceed what you send out. Beyond that, your excess cash should be applied toward your investment goals, build cash reserve and paying down debt
Here’s how to achieve these objectives:
Build your cash reserve – Your ability to access cash when you need it is critical —so that when something goes awry, you can still pay your regular and everyday expenses without undermining your long-term financial goals. This is why it’s so important to create short and long-term cash reserves, ideally through a systematic saving strategy.
Your short-term cash reserve is for those minor emergencies that seem to crop up all too frequently —car repairs, a leaky roof, a broken appliance –and should act as a cushion of at least six months’ worth of everyday expenses set aside in case something even more significant happens, such as a job loss or disability. Your cash reserve typically consists of investments with higher liquidity and lower returns (e.g., savings accounts, money market mutual funds, fixed deposits). Without cash reserves as a safety net, tough times could lead to even worse times —especially if you need to start cashing in your longer-term investments to get by which will have a detrimental impact on your long term financial goals.
Pay down debt – In a society where credit is growing and more & more financial institutions are luring the client with newer ways of borrowing, it’s common to have debt. But just because you have debt doesn’t mean you can’t be smart about it. One way to manage debt wisely is to pay down your higher-interest balances first.
Let’s say you have a balance on a credit card with a rate of 18% and a car loan that offers a 10% rate. It makes sense to apply any extra money toward the credit card first.
Cornerstone #2: Making sure you’re protected.
Market and economic fluctuations can impact your financial stability, while changes to your family, career and health can affect your long-term goals. This is why a solid protection plan is important, so you won’t have to deplete your savings and investments if you’re ever faced with a financial crisis. No one likes to think about how an unexpected illness or disaster could devastate their financial situation. But unwelcome surprises can unravel years of careful saving in a very short time. The fact is, most people have serious gaps in their coverage, or don’t have protection to address key risks. Here’s how to make sure your protection cornerstone is sound:
Life insurance: There are few guarantees in life, but one is that we will all ultimately die. This is why it’s so important to have life insurance —because even though you will one day be gone, your loved ones will continue on. And without the monetary support you currently provide, they may not be able to survive financially. So make sure you take advantage of any life insurance.
Looking beyond life covers: Most of us think that protection plans are synonymous with life insurance. However, that’s the case there many other things that you must protect to keep your financial situation stable and under control. Some such protections policies are:
• Permanent disability insurance -If a sudden injury or illness prevents you or your spouse from working, it could derail your lifestyle as well as your plans for the future.
• Householder’s insurance -Considering the monetary and emotional importance of this asset it is surprising to see that many of us don’t have a householder’s policy that covers our house against fire, burglary and other such risks.
• Health insurance -Having a sufficient health cover is an absolute necessity in the wake of rising health care costs. Most individuals have a health cover only through their employers which is often inadequate.
• Auto insurance -We look at motor policies merely from a compliance perspective and buy whatever our friends our buying or what the agent suggests. However, your auto insurance must cover aspects like cashless facilities across a large number of motor garages, warranty on repairs etc.
Review and reorganize: While you would have purchased insurance policies, it’s also important to periodically review your insurance policies as part of your financial protection plan to ensure it keeps pace with ever-changing circumstances. For example, if there has been an addition to your dependants, let’s say a child, you may need more coverage.
Cornerstone #3: Investing with discipline and diversification
Investing is key to long-term financial success, but it’s also one of the most complex and difficult cornerstones to master. As you know, the financial markets can be fickle, frustrating and full of twists and turns —even in a single day. Staying on track for the long haul involves discipline, regular investing and diversification.
Stay disciplined: Having a comprehensive strategy for investing is critical, but equally important is sticking to that strategy for the long run —even when the markets are in flux and causing emotional mayhem. Investing is often a tug-of-war between the head and the heart. Your financial advisor can help by maintaining an objective focus on your portfolio.
It’s your time in the markets that matters: Volatile markets tend to make individual investors nervous, causing them to question the timing of their purchases and sales. But history proves that time—not timing—is what really matters.
The practice of timing investment purchases and sales based on the market’s ups and downs is difficult and rarely successful. But the strategy of putting your money to work in the market for the long haul is tried and true. That’s because staying invested means you won’t miss the market’s top-performing days. To make ongoing investing a priority, take advantage of systematic investing opportunities. Also consider these strategies to complement your long-term investment plan:
Rupee-cost averaging: This investment strategy involves consistently allocating a set amount toward the investments with a regular schedule (weekly, monthly, quarterly), regardless of the market’s short-term performance. Over time, this may lower your average cost per share and could even help smooth out the effects of market volatility.
Diversify: Diversification is spreading your investments across asset classes to ensure that you are not exposed to just one asset class; simply put it’s about not putting all your eggs in one basket. Building an effective mix of stocks, mutual funds, bonds, cash, real estate and other assets can help reduce the volatility in your portfolio and potentially result in more consistent returns. Not all assets perform in a similar fashion from year-to-year. For example, bonds may generate positive returns in a given year when equity mutual funds are down (this may not always occur, but it has happened historically).
Cornerstone #4: Using smart tax strategies
Diversifying your investments is great, but there’s no need to stop there; you can also consider smart tax strategies. While we have discussed these in detail in our last issue here is a brief summary of what you can do at this last hour.
Don’t buy what you don’t need: Insurance policies are often bought as tax saving instrument rather than protection. Therefore, if you are buying an insurance policy at the last minute make sure it provides an adequate cover and augments your overall protection requirement. Similarly if you are looking at tax saving mutual funds, keep in mind that equity market investments carry inherent risk. Therefore, always touch base with your advisor to buy what suits your overall risk profile.
Recycle and use your old investments: If you have been investing in financial instruments such as equity-linked savings schemes for the last few years, consult with your advisor to understand if you can benefit by redeeming investments made 3 years ago and re-investing that amount this year.
In such a case, you need not pay any long-term capital gains as you will be redeeming after more than one year. However, do remember to check the Net Asset Value (NAV) of your investments to avoid any potential losses due to downward fluctuations at the time of redemption.
Conventional options might not be the best: Investment in NSC is a good option from tax saving perspective in debt category but one has to keep in mind that interest accrued on NSC is taxable on year-to-year basis and thus reducing the overall benefit of tax saving.
Investment in PPF at the last minute means that you will only get interest for one month and not the entire 8.5%. Also one has to keep in mind the lock-in period.
By Mr. Bimal Gandhi, Chairman, Ameriprise India Pvt. Ltd. ; Executive Vice President – Enterprise Services, Ameriprise Financial Inc.