More often than not, out of the challenges we face in life, we face various financial obligations in different stages of life. They range from medical expenses, education expenses and other miscellaneous expenses. In most cases, a lot of challenges stem from lack of money, often caused by poor financial planning. This week, we follow up our previous focus on Investment Options in the Kenyan Market, where we now look at the importance of financial planning and the various considerations to make, based on one’s own characteristics, needs and preferences.
Therefore, we shall be discussing the following:
- What is Personal Financial Planning?
- The Financial Planning Process,
- The Key Considerations to Make,
- Conclusion.
Section I: What is Personal Financial Planning?
Personal Financial Planning refers to a systematic approach towards managing one’s finances in an effort to maximize the use of these resources in order to achieve one’s financial goals and objectives. In other words, it is allocating resources optimally so as to realize one’s financial goals. Having a sound personal financial plan helps reduce and possibly eliminate financial distress arising from various responsibilities and unexpected situations. Having highlighted the need for a personal financial plan, it is key to note that financial planning, to a large extent, depends on one’s age, the responsibilities at hand, and future objectives.
Section II: The Financial Planning Process
Personal financial planning is a continuous process that can be achieved through the following steps:
- Assessment: This is the first step towards financial planning and it involves identifying factors that are likely to affect one’s financial plan. In this step, an individual will need to look at their income statement, spending habits, lifestyle and see how each of them will affect their financial plan. Some of the factors likely to inform one’s financial plan include:
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- Age: Younger people have time on their side and can therefore make riskier investment decisions as they have time to recover if they end up making losses. Their investment of choice would include real estate and equities, which allow the investor time to grow value in their investment. For an older person, time is limited and therefore high-risk investments are not an option. They prefer safer investment options that offer steady and predictable income, which include; government backed assets such as bills and bonds, which offer an almost guaranteed return after a given period of time. They may also invest in various collective investment schemes such as fixed income or money market funds, which are professionally managed, offer liquidity, periodic income and principal protection;
- Risk Profile: Some people are more risk averse than others, and they will generally avoid riskier investment decisions which means that their financial planning decisions will be geared towards safer investment plans. Their portfolio will most likely include investment instruments such as treasury bonds, bills and bank deposits. They can also invest in these securities through money market funds or fixed income funds. As for the risk takers, they will channel their planning towards high risk investments such as real estate and equities, with the aim of generating higher returns;
- Income: An individual’s income will affect their disposable income, and the amount of money they have left to invest. With proper financial planning, the higher the income, the more disposable income that one has to place into savings and investments. This however does not mean low income earners can’t invest. Through the various types of collective investment schemes and structured products, individuals can gain access to various securities such as bank deposits, treasury bills, bonds and equities, given the relatively lower initial investment requirement. Furthermore, it means they have to put in more effort in prioritizing their needs to achieve a reasonable disposable income; and,
- Number of Dependents: People with few dependents have the freedom to make riskier investment decisions as compared to those with many people depending on their income.
- Goal Setting: In this step, one should outline their future financial targets. An individual could have multiple goals, some long-term and others short-term. These different goals will influence the path one takes towards achievement of their financial objective. Your financial planning goals should be measurable and achievable by one or a combination of the following four practices:
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- Saving: It entails setting aside part of your income in an account. Efficient saving requires discipline, and here are a few tips to guide you. Firstly, save with a goal. Secondly, save first, and then spend what you have left. Thirdly, don’t just save, invest;
- Investing -There are different asset classes that one can consider. An investor will be drawn to a different channel based on their risk appetite, the returns expected and the liquidity requirement. The most common asset classes include:
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- Equities: They represent ownership interest in a company. They are considered as traditional investments that are relatively liquid, highly volatile and are therefore considered risky. They are suitable for long term investors and offer returns in form of dividends and capital appreciation,
- Fixed Income: These are securities that offer fixed returns to investors. They are also considered as traditional investments that are moderately liquid, have low volatility and are therefore considered less risky. They are suitable for medium term investors and offer returns in form of interest income and capital appreciation. They include deposits, bonds and commercial papers,
- Real Estate: This involves investment in property and land. Real Estate is considered as an alternative investment that is illiquid, relatively stable and uncorrelated to traditional investments. They are suitable for long-term investment plans, which makes them a risky investment. Real Estate offers returns in form of rental yield and price appreciation, and,
- Private Equity: Private equity involves investing in a young, private company looking for growth capital. They are suitable for high net worth individuals with a long-term investment plan, which makes them a risky investment. Private Equity offers returns in form of dividend and capital appreciation.
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As you invest, it is important to diversify one’s portfolio. This means that you invest in different instruments so as to spread your risks across them.
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- Debt and Debt Management - Is debt good or not? Debt is only good if you are borrowing for investment or for future financial gain such as business, education, or property. Here are a few do’s and don’ts for debt management;
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- You should never use more than 1/3 of your net income in loan repayment,
- Never borrow for things you desire but don’t need,
- Avoid borrowing on consumption items, and
- Live within your means.
- Budgeting - Lastly, is the discipline to budget around the resources we have. As you budget, give priority to necessary expenses and try as much as possible to cut down on discretionary expenses.
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- Plan Creation and Execution: The financial plan details how to accomplish the goals identified in the step above, the time it may take to achieve each, and the best step to take towards achieving it. Execution refers to putting the created plan to action. A well laid out plan should highlight the following items:
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- Suitable channels and investment instruments that will assist you in achieving your goals: This involves making decisions on the best ways to attain your financial targets. This may be through saving, proper budgeting, cutting on expenses, and through investing, and,
- Timelines: This will indicate how long you are willing to invest in a given investment instrument. Long-term investments may be most suitable for long-term goals. This is because, long-term investments offer higher returns, and long-term goals often have higher cash requirements.
- Monitoring and Reassessment: A financial plan needs to be monitored for possible adjustments or reassessments. A review allows you to analyze your individual investments and determine if they are worth keeping. The following factors should prompt one to make changes on their financial plan during a review:
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- Status of Set Goals: Determine whether your pre-determined goals have been achieved or not and whether or not the unachieved goals are still achievable, given the present circumstances,
- Change in income: Any significant adjustment in income would directly impact your financial plan and may lead to early maturity or a delay of set goals and therefore affect the set timelines,
- Number of dependents: A change in number of dependents may mean that one has more or less disposable income to put into investments or vice versa, and,
- Change in Risk Appetite and Risk Tolerance: An individual’s risk appetite and risk tolerance may change as one progresses with life. Age, change in income and a change in number of dependents are the factors likely to affect one’s risk appetite and tolerance levels.
Section III: The Key Considerations to Make
The investment considerations to be made will to a large extent depend on one’s individual risk tolerance and appetite, which depends on the age and the level of income. The table below summarizes the investment allocation depending on the highlighted factors.
|
Investors Age |
Expected Risk Profile |
Income Level |
Skew investments towards |
Reasoning |
|
Below 25 |
High |
Starting up so not high |
Real Estate and Equities |
Has a long investment horizon to withstand volatility and get enhanced returns |
|
25- 35 |
High |
Medium to high |
Real Estate and Equities |
Few cash flow requirements. Still has time to withstand volatility |
|
35-45 |
Medium |
Medium to high |
Real Estate, Equities and Fixed Income |
There are constant cash flow obligations. Still has time to withstand medium volatility |
|
45-60 |
Medium |
Medium to high (Generating income from prior investments) |
Real Estate, Equities and Fixed Income |
There are constant cash flow obligations. Still has time to withstand volatility |
|
Above 60 |
Low |
Low or non-existent |
REITS and Fixed Income |
Stability of income is key |
Section IV: Conclusion
If for nothing else, personal financial planning is important for an individual’s present and future financial stability. Ultimately, with properly planned finances, peace of mind is almost guaranteed. Similar to medical planning, financial planning is important for the following reasons:
- Defining Financial Goals – Most people spend their time planning on how they wish to purchase a plot or a car or even that well deserved holiday. Having a financial plan allows you to identify your financial goals as opposed to focusing on “side-shows”. Thus one is able to focus on execution which ultimately increases the chances of realizing their goals,
- Income Management – When you have a defined plan, it is easier to manage your income through budgeting and prioritizing spending. It also helps you to pick out wasteful expenditures and adapt quickly when your financial situation changes,
- Measuring Progress – Once you have a plan in place, it is easy to track your progress towards your financial goals. It instills discipline when it comes to maintaining set targets & goals,
- Financial Understanding – By taking time to plan your financials, you get to understand better and take control of your financial lifestyle,
- Asset-Liability Management – through financial planning, one is able to distinguish the real value of an asset since some of them come with liabilities attached to it. For example; buying a car that needs to be serviced every 3-months, needs to fueled and requires an insurance cover in case of accidents,
- Emergencies – through planning you are able to set aside an investment with high liquidity such as a money market fund or bank deposit, which will act as a safety net during times of emergency, and,
- Comfortable Retirement- In order to enjoy your retirement years, one needs a stable source of income and given that formal employment is no longer an option, it is important to sign up to a registered Retirement Benefits Scheme and make regular contributions in your employed years. Aside from reducing poverty in old age, some of the benefits of saving through a retirement benefits scheme include:
- Provision of regular income to replace earnings in retirement, and,
- Provision of lump sum benefit income for surviving dependents in the event of your passing.
Disclaimer: The views expressed in this publication are those of the writers where particulars are not warranted. This publication is meant for general information only and is not a warranty, representation, advice or solicitation of any nature. Readers are advised in all circumstances to seek the advice of a registered investment advisor
