Aug 23, 2012 04:37 PM IST | Source:

Five steps to logical financial decisions

How do we ensure that financial decisions taken are logical ones rather than emotional ones? The key to successful financial planning is to analyse our needs and accordingly arrive at rational solutions.

Mukund Seshadri

Mr. Karthik Rajan is a 37 year old married man and has one child, aged 7. Four years back, Karthik and his wife were looking for an apartment in the price range of about Rs. 50 lacs but ended up buying one worth Rs. 80 lacs. The reasons for buying a house beyond his means were peer and family pressures. He moved into his new apartment and immediately took a personal loan to renovate his house. Plush interiors coupled with state of the art furnishings cost him almost Rs. 10 lacs. But that was not all, Karthik believed that having a car especially a high end one is a necessity and so took a car loan for the same.

Today Karthik is in a serious financial mess. His EMI’s are touching the roof and disposable income is dropping by the day. He has to pay for his son’s increasing cost of education and maintain an extravagant lifestyle. The future is scaring him. Such problems have become common today in every second house.

The question is “How do we ensure that financial decisions taken are logical ones rather than emotional ones?”  The key to successful financial planning is to analyse our needs and accordingly arrive at rational solutions. 

The first step involves a clear demarcation between needs and desires. Need is a necessity without which day to day functioning could be hampered. However most of the times we tend to believe a desire to be a need. For e.g. buying a car could be a need, but having a high end model could be a desire.

The above step needs to be followed up by drawing up a personal balance sheet and cash flow statement. Before going ahead with any purchase a personal net worth statement is a must. This needs to be updated atleast once in six months. This will help us know the amount of money available for an expense and the cost at which the money is deployed. For e.g. if a house is to be purchased and the money is getting deployed from retirement fund or emergency fund then it is important one re-thinks his/her decision.

The third crucial point which one needs to look at is whether the money is being spent to acquire an asset or a liability. Assets generate income while liabilities cause depletion of wealth. So, when there is a major expenditure, what needs to be looked at is what would be the cost of servicing the same in the future and also, whether one would get a good valuation when the asset is disposed off in the future. Eg. A self-occuipied property is a liability in comparison to a property which is leased out. However, a person needs to weigh the pros and cons before he purchases a property for the purpose of investment.

Many-a-times, an expenditure incurred is only considered as the cost of acquiring it and not the cost of maintaining it. A simple example can be that of a buying a house with amenities like a swimming pool, a gym, club house etc. wherein the monthly outgoing i.e. the variable cost incurred is high irrespective of the fact whether these facilities are used or not. So knowing the fixed and variable expenditure becomes the fourth important point to arrive at a correct financial decision.

The fifth critical point is to understand the cost per usage of an asset. For e.g. in financial planning we often come across people wanting a weekend home. When asked how many times in a year will they actually visit that place or would they be happy visiting the same place every time, they don't have an answer. The money set aside for buying a weekend home could be invested in such a way that even the interest income could suffice for tour expenses at different locations.

So an effective plan is not a matter of quick, emotional decisions, but a logical solution to various financial needs.

Mukund Seshadri is the senior partner at MSVentures Financial Planners.

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