While doing financial planning we always talk about taking an insurance policy. Usually financial advisors would ask you to take the types of policies
1) Life
2) Health
3) Home
I am not talking about car, is because the law forces you to have one anyway.
Now let’s look at Life. The insurance agents usually will show you a range of policies, from wholelife, moneyback, etc. and they talk of riders, to take care of health, accident, etc. But what is best for you? First let us try and understand what is life insurance? Life Insurance is usually to take care of your loved ones incase something happened to you. So it would be best to take a policy, which would take care of the financial needs of you and your family in case something happens to you. You should not look at insurance as an investment.
Before we go into anything lets see how insurance works. Insurance does not protect you against something happening to you, it covers the consequence of an event. So if that is the case, why should we look at is an investment to get something in return. You should buy an insurance hoping the event does not happen, but if does happen. The reason for which you have taken the insurance will be taken care of. The premium you pay, is an expense to buy Peace of mind.
Basically what happens when you buy an insurance policy with a return of money? The insurance company breaks up the premium into 2 parts. One risk premium and another investment. The risk premium goes as expense to buy you peace of mind. Then investment premium is invested and what you get is return of your investment premium. So why should you ask an insurance company to do investment for you?
The core competency of an insurance company is not investment. You have scores of investment companies. Also check the historical returns of the same amount of investments with an insurance company vis-à-vis an investment company. The returns you get from an insurance company have always been less. So the best thing to do is go in for term insurance only.
Term insurance provides insurance for a specific period of time, or “term”. Term insurance provides only “pure” insurance protection and does not have the savings or investment feature. This type of insurance offers the users a choice of terms from 1 year renewable up to 30 year terms. The premium for the term remains the same throughout the term; the most popular nowadays is the 20 year term. In certain cases you can also opt for a term to a specified age, usually 65.
Saturday, November 29, 2008
Sunday, November 16, 2008
Budgeting for Financial Planning
We always speak of Financial Planning and try to make plans. One of the most important parts of Financial Planning is Budgeting. It is one of the things we don’t like to do. It’s only when we start writing down our incomes and expenses and put a budget for our expenses, we would go one step ahead in Financial Planning.
It is very important to be as detailed as possible. Only then you would know where your money is coming from and where it is going. How much time do you think it would take you to write a monthly financial budget? 30 minutes to 1 hour. That’s all. First time you might take a bit longer, but after that it is easy.
How do we go about? First collect all your financial statements, just as you do for the purposes of your income tax. Some of the examples are Bank Statements, salary slips, investment documents, insurance, etc.
Open an excel sheet and make 12 monthly columns.
Next start making a note of all your incomes and the months in which you would got it and how much. Put the gross amount in the incomes write each category of income separately. Put the deductions in the expenses or investments.
Now start noting down all your monthly expenses; Fixed and variable. Fixed expenses are those which would be the same every month. Eg. Rent or maintenance charges, EMI’s, Insurance premiums, etc. Variable would be those which would change on monthly basis. Eg. Groceries, travelling expenses, gifts etc.
Take into account special occasions and budget for them. Eg. Birthdays, holidays, festivals, etc.
Now total up your incomes and expenses and presto you have your budget ready. Our first step is done. You would have some months where expenses would be more than income or the other way around.
If you have excess income, you can plan your investments or keep the money aside for months where expenses would be more. Also in case expenses would be more in a particular month, you could readjust your expenses.
Now review your budget with actual on a monthly basis and adjust your budget accordingly. Do this regularly.
It is very important to be as detailed as possible. Only then you would know where your money is coming from and where it is going. How much time do you think it would take you to write a monthly financial budget? 30 minutes to 1 hour. That’s all. First time you might take a bit longer, but after that it is easy.
How do we go about? First collect all your financial statements, just as you do for the purposes of your income tax. Some of the examples are Bank Statements, salary slips, investment documents, insurance, etc.
Open an excel sheet and make 12 monthly columns.
Next start making a note of all your incomes and the months in which you would got it and how much. Put the gross amount in the incomes write each category of income separately. Put the deductions in the expenses or investments.
Now start noting down all your monthly expenses; Fixed and variable. Fixed expenses are those which would be the same every month. Eg. Rent or maintenance charges, EMI’s, Insurance premiums, etc. Variable would be those which would change on monthly basis. Eg. Groceries, travelling expenses, gifts etc.
Take into account special occasions and budget for them. Eg. Birthdays, holidays, festivals, etc.
Now total up your incomes and expenses and presto you have your budget ready. Our first step is done. You would have some months where expenses would be more than income or the other way around.
If you have excess income, you can plan your investments or keep the money aside for months where expenses would be more. Also in case expenses would be more in a particular month, you could readjust your expenses.
Now review your budget with actual on a monthly basis and adjust your budget accordingly. Do this regularly.
Sunday, November 9, 2008
Hedging to make money
Hedging is an investment in order to reduce or nullify a risk taken. It is a strategy to reduce risk.
Let’s take an example I have to receive US$ 100, 3 months from today, the current exchange rate is US$ 1 = Rs. 47. So if the exchange rate remains steady I would receive Rs.4700. But I am not sure what would happen with the exchange rate, so I can sell a 3 month future contract at US$ 1 = Rs. 47. In this way I am assured of Rs. 4700, when I get my US$. In reality what happens, say after 3 months the exchange rate is US$ 1 = Rs. 45. I will receive Rs. 4500 only from the bank, but I will gain Rs. 200 from my future contract.
So is hedging normal, YES. We do it in our day to day life.
By the way, even buying a health insurance is a Hedge. We hedge our risk of an uncertain future event of falling sick and being hospitalized. What we are basically doing is making an investment to reduce or nullify our risk to bankruptcy.
How can we use this to increase our profits? Let us say I feel that there would be an announcement today that will benefit the Telecom Industry and I feel Tata Tele is better than Reliance Communication. But I am not a risk taker, so what can I do?
Let’s say the current price of Tata Tele is Rs. 16 and Reliance Communication is Rs. 216.
So what I will do is buy 63 shares of Tata Tele that will be Rs. 1008 (63 X 16) and short sell 5 shares of Reliance Communication that will be Rs. 1080 (216 X 5)
Now if there is an announcement, since Tata Tele is a better company the price of its share would definitely grow at a faster rate than the price of Reliance Communication. Let us assume the price Tata Tele became Rs.18 and Reliance Communication becomes Rs. 238. What happens? If you sell Tata Tele you will get Rs. 1197 (63 X 19) and you will have to pay for Reliance Communication Rs. 1190 (238 X 5).
Net amount you would have made is
Tata Tele – Profit Rs 189 (1197 – 1008) and Reliance Communication – Loss Rs. 110 (1190 – 1080)
Net Profit Rs. 79 (189 – 110)
But what would happen if the announcement is unfavorable. The prices of both the shares would fall, but Reliance communication would fall at a faster rate than Tata Tele. Let us assume at the end of the day the price of Tata tele became Rs. 14 and Reliance Communication become 173.
Net amount you would have made would be
Tata Tele – Loss Rs. 126 (63 X (16 – 14)) and Reliance Communication – Profit Rs. 215 (5 X (216 – 173))
Net Profit Rs. 89 (215 – 126).
So whatever the news you would make money. But the key would be to know which is a better company.
Let’s take an example I have to receive US$ 100, 3 months from today, the current exchange rate is US$ 1 = Rs. 47. So if the exchange rate remains steady I would receive Rs.4700. But I am not sure what would happen with the exchange rate, so I can sell a 3 month future contract at US$ 1 = Rs. 47. In this way I am assured of Rs. 4700, when I get my US$. In reality what happens, say after 3 months the exchange rate is US$ 1 = Rs. 45. I will receive Rs. 4500 only from the bank, but I will gain Rs. 200 from my future contract.
So is hedging normal, YES. We do it in our day to day life.
By the way, even buying a health insurance is a Hedge. We hedge our risk of an uncertain future event of falling sick and being hospitalized. What we are basically doing is making an investment to reduce or nullify our risk to bankruptcy.
How can we use this to increase our profits? Let us say I feel that there would be an announcement today that will benefit the Telecom Industry and I feel Tata Tele is better than Reliance Communication. But I am not a risk taker, so what can I do?
Let’s say the current price of Tata Tele is Rs. 16 and Reliance Communication is Rs. 216.
So what I will do is buy 63 shares of Tata Tele that will be Rs. 1008 (63 X 16) and short sell 5 shares of Reliance Communication that will be Rs. 1080 (216 X 5)
Now if there is an announcement, since Tata Tele is a better company the price of its share would definitely grow at a faster rate than the price of Reliance Communication. Let us assume the price Tata Tele became Rs.18 and Reliance Communication becomes Rs. 238. What happens? If you sell Tata Tele you will get Rs. 1197 (63 X 19) and you will have to pay for Reliance Communication Rs. 1190 (238 X 5).
Net amount you would have made is
Tata Tele – Profit Rs 189 (1197 – 1008) and Reliance Communication – Loss Rs. 110 (1190 – 1080)
Net Profit Rs. 79 (189 – 110)
But what would happen if the announcement is unfavorable. The prices of both the shares would fall, but Reliance communication would fall at a faster rate than Tata Tele. Let us assume at the end of the day the price of Tata tele became Rs. 14 and Reliance Communication become 173.
Net amount you would have made would be
Tata Tele – Loss Rs. 126 (63 X (16 – 14)) and Reliance Communication – Profit Rs. 215 (5 X (216 – 173))
Net Profit Rs. 89 (215 – 126).
So whatever the news you would make money. But the key would be to know which is a better company.
Monday, November 3, 2008
Long Term Financial Planning
We looked at short term needs, but are those enough? We also need to look at our long term needs. We would not be working through out our life’s, so we would need to make money work for us. This I picked up from the book “Rich Dad Poor Dad”. It’s a beautiful book, it really wakes you up.
What are the long term needs we should take care of?
• Health care
• Care of our near and dear ones
• Retirement care
• Luxuries
Health care: Life expectancy is growing and the longer you live the more it becomes necessary to take care of your health or medical costs. This is most important. Medical costs are going up and will keep going up. You would not want all your savings going off in case you fall sick. So it’s best to have a health insurance in place. At a younger age we may feel it’s not important, but as we grow older it becomes very important. It becomes difficult getting an insurance policy after the age of 40. It’s better to get one before that. Now the question comes as to what should be the amount of health insurance. It would differ from person to person. The points to be considered are how long do you expect to live, Marital status, Gender, Lifestyle and Family health history.
Care of near and dear ones: Here we need to see how many dependents we have and for how long they would depend on us. Some points to be considered are Spouse, Children (include education and marriage expenses), Parents and others.
Retirement care: Here we should take into account the cost of living. Note our costs usually go up as we age. It might sound funny, but it’s true. Also is boring to just sit in the house and be idle. It is best to work on what you would do once you retire. Lot’s of people just spent their entire life working for money and not doing what they longed to do. Take up such tasks, they will keep you occupied. Find out what you would be able to do when you retire and start planning for the same when you can. Saving for retirement is not very complicated. It’s easy. Remember the power of compounding (when you start investing early, you would need to invest less to reach the same target on retirement), Pension plans, tax benefits (the government gives you tax benefits for investing, invest it for your retirement), Employer contribution (This is one of the best, it is not part of your taxable income e.g. PF). Even if you do this little bit it goes into making a big corpus for your retirement
Luxuries: Don’t forget to pamper yourself on retirement. You need to enjoy your life as well. Why did you work for so many years? Plan a separate corpus for planned holidays after retirement on a regular basis.
Plan and Enjoy life Longer.
What are the long term needs we should take care of?
• Health care
• Care of our near and dear ones
• Retirement care
• Luxuries
Health care: Life expectancy is growing and the longer you live the more it becomes necessary to take care of your health or medical costs. This is most important. Medical costs are going up and will keep going up. You would not want all your savings going off in case you fall sick. So it’s best to have a health insurance in place. At a younger age we may feel it’s not important, but as we grow older it becomes very important. It becomes difficult getting an insurance policy after the age of 40. It’s better to get one before that. Now the question comes as to what should be the amount of health insurance. It would differ from person to person. The points to be considered are how long do you expect to live, Marital status, Gender, Lifestyle and Family health history.
Care of near and dear ones: Here we need to see how many dependents we have and for how long they would depend on us. Some points to be considered are Spouse, Children (include education and marriage expenses), Parents and others.
Retirement care: Here we should take into account the cost of living. Note our costs usually go up as we age. It might sound funny, but it’s true. Also is boring to just sit in the house and be idle. It is best to work on what you would do once you retire. Lot’s of people just spent their entire life working for money and not doing what they longed to do. Take up such tasks, they will keep you occupied. Find out what you would be able to do when you retire and start planning for the same when you can. Saving for retirement is not very complicated. It’s easy. Remember the power of compounding (when you start investing early, you would need to invest less to reach the same target on retirement), Pension plans, tax benefits (the government gives you tax benefits for investing, invest it for your retirement), Employer contribution (This is one of the best, it is not part of your taxable income e.g. PF). Even if you do this little bit it goes into making a big corpus for your retirement
Luxuries: Don’t forget to pamper yourself on retirement. You need to enjoy your life as well. Why did you work for so many years? Plan a separate corpus for planned holidays after retirement on a regular basis.
Plan and Enjoy life Longer.
Sunday, November 2, 2008
Short term financial planning
So we decided that we need to invest and invest is such a way that we do not lose our capital. What are the options we have? When it comes to savings, it depends on your needs. Let’s look at the options available for our short term needs.
Savings Accounts
All of us have a savings account, it is a safe investment or should we say savings. How much do we earn? Currently we get 3.5% per annum. Yes, that is income, but the inflation is much above that. Your money does not work for you here. After taking into account inflation, you would actually be losing money. This account is only meant to keep you liquid. Therefore here money should be kept only to meet our average monthly expenses.
Term Deposits (Fixed Deposits)
This gives us a return from 8 to 10% per annum depending on the bank and tenure. The return on this is slightly better than savings Account and closer to the inflation rate. Indirectly our money would be growing at approximately the same rate of inflation. Taking into account some emergency situation, about 3 months current average expenses should be kept in fixed deposits. If you withdraw your money before maturity, the bank imposes a penalty, which could wipe off the interest earned. That should not matter since this money was kept for emergency use. If you are looking for a large investment in a few months down the line and the money is lying in your Savings account it would make more sense to put the money in Term Deposits for a few months. Banks give you such flexibility. You could also go for Money Market Mutual funds or Fixed maturity plans.
Money Market Mutual Funds
These funds usually give you returns in line with the market and just above inflation rate. This would be more like the Term Deposits but better returns. But this comes with more restrictions, especially on withdrawals. Though there is insurance on Savings accounts and Term Deposits to the tune of Rs. 1 Lakh, there is no such insurance on most of the instruments we would speak about from here onwards.
RBI Bonds, NSC’s and other instruments through post office
All of these are more or less like the Term Deposits offered by Banks. The main problem is liquidity. They are not as liquid as Term Deposits. These deposits are assured by the government of India. You could also get loans against these instruments.
Depending on your needs you can look at these different options. Please note the above options are only for your short term needs.
Savings Accounts
All of us have a savings account, it is a safe investment or should we say savings. How much do we earn? Currently we get 3.5% per annum. Yes, that is income, but the inflation is much above that. Your money does not work for you here. After taking into account inflation, you would actually be losing money. This account is only meant to keep you liquid. Therefore here money should be kept only to meet our average monthly expenses.
Term Deposits (Fixed Deposits)
This gives us a return from 8 to 10% per annum depending on the bank and tenure. The return on this is slightly better than savings Account and closer to the inflation rate. Indirectly our money would be growing at approximately the same rate of inflation. Taking into account some emergency situation, about 3 months current average expenses should be kept in fixed deposits. If you withdraw your money before maturity, the bank imposes a penalty, which could wipe off the interest earned. That should not matter since this money was kept for emergency use. If you are looking for a large investment in a few months down the line and the money is lying in your Savings account it would make more sense to put the money in Term Deposits for a few months. Banks give you such flexibility. You could also go for Money Market Mutual funds or Fixed maturity plans.
Money Market Mutual Funds
These funds usually give you returns in line with the market and just above inflation rate. This would be more like the Term Deposits but better returns. But this comes with more restrictions, especially on withdrawals. Though there is insurance on Savings accounts and Term Deposits to the tune of Rs. 1 Lakh, there is no such insurance on most of the instruments we would speak about from here onwards.
RBI Bonds, NSC’s and other instruments through post office
All of these are more or less like the Term Deposits offered by Banks. The main problem is liquidity. They are not as liquid as Term Deposits. These deposits are assured by the government of India. You could also get loans against these instruments.
Depending on your needs you can look at these different options. Please note the above options are only for your short term needs.
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