If you have just started earning, then consider these basic rules of investing, as you shape your finances. Setup emergency corpus, have your own health insurance, secure your dependents, save substantially, focus on risk management, start goal based savings and pay attention to asset allocation principles.
Mahip, a 24 years management graduate was happy to get a job in a manufacturing firm, as a manager with a decent salary. Few months later he bought a car with an EMI of approximately Rs 8000. He also started using his credit card and now half of his salary was used to pay his card bills. His parents suggested him to at start saving but he kept ignoring. He met with an accident and was hospitalized. He had no health cover and parents had to pay the bill. Unable to work for next one month, parents also funded his credit card and other bills. Mahip finally realized his mistake, having learned the hard way.
To avoid these mistakes, we have these 8 tips to help you shape your finances.
1. Create an emergency fund equivalent to 3-6 months of expenses – In the above example of Mahip, one can clearly observe how important emergency fund is. In case if he had sufficient emergency fund with him then definitely he would be in a better position to pay his bills. So if your overall expenses are around 60,000 per month including EMI and other variable expenses, then you should always maintain around Rs. 3 Lac in your emergency funds. Based on the situation, your need of having emergency corpus can be even higher.
2. Buy a personal health insurance cover – Almost every employer provides the facility of group health insurance. However, it is still advised to buy a personal health insurance cover on your own to avoid dependency on the employer. Now, there is no standard formula to calculate the amount of the health insurance cover. One can look at the medical history, place of stay, hospitalization expenses incurred in past and the premium one can afford.
3. Use ‘need based’ approach to calculate your life cover – Although there are many methods to calculate the right amount of life cover, however at young age “Need Analysis method” may just work fine. You can consider financial liabilities (net of assets) and household expense corpus that your dependents will need till their life time. Total of the net financial liabilities and the household expense corpus amount should be ideally be your insurance cover. Online term plan is recommended, being the cost effective solution.
4. Target a substantial saving rate –Most of the people still follow the old rule of saving i.e. “Income – expense = Savings.” This way people save less and spend more. However, if you follow the reversed rule “Income-saving = Expenses” then chances are high that you may end up spending less. Start saving at least 50% of your income every month as at this stage of life the responsibilities are less.
5. Save taxes, the smarter way – Insurance policy is often bought just to save the tax. There are many tax saving instruments which make a smarter choice. Beyond an online term plan, the required savings to meet Section 80 C quota can be met through investing in Equity Linked Saving Scheme. These have a lock in period of just 3 years, are not expensive and can generate substantial returns linked to the market performance. One can also consider investing into Public Provident Fund to save tax.
6. Invest in Financial Risk Management – It is a prudent measure to proactively manage financial risks on one’s life & health at minimum. Once these are done, one can look at supplemental covers like personal accident, critical illness & hospital cash covers. While your situation can be different, a thumb rule of spending about up to 10% of your income on risk management is a good practice.
7. Start goal based savings, Include retirement goal– At this age, one typically likes to buy a car, get married and buy a house. So while saving for these goals, one should also allocate savings towards your retirement. By starting early for retirement goal, one gets substantial benefits through compounding principle. The amount can be increased every year with an increase in income and lifestyle. Remember, you can get a loan to buy car or a house but no one funds your retirement.
8. Pay attention to Asset Allocation - Money is very important in anyone’s life and to invest it without having any proper strategy is very risky. It is always advised to go with the proper “Asset Allocation” which is based on the individual’s risk profile, current financial situation and future goals. For example if the goal is of short term it is better to keep money safe in debt instruments and if goal is of long term equity exposure should be high. Remember regular review and rebalancing is important to achieve future goals.
The author is a Certified Financial Planner (CFP) and specializes in helping young families to setup their personal finance roadmap. He is associated with www.gettingyourich.com, a Mumbai based financial planning firm.