These three elements are essential to a successful financial plan:
- Net Worth
- Cash Flow
- Financial Goals
You can and should do these for yourself. A professional financial planner could do these things, but you will need to provide the raw data and only you can set your financial goals. It is preferable to do the net worth and cash flow on a computer using any of the available software, but you can also do them on paper. Your goals should be set up as short-term, achievable within 2 years; mid-term; achievable within 3-7 years; and long-term. The goals will change as time progresses.
These three elements form your financial road map. The Net Worth is the “You Are Here”, your Financial Goal is the place you want to get to and the Cash Flow is the vehicle you have to move from – “You Are Here” to where you want to be – “Goal.” Investing without first doing these three things would be like starting out on a trip not sure where you were leaving from, how you were going to get there, and where you were going.
Analyze Your Assets
It’s easy to get caught up in day-to-day living, to be too busy to look ahead. But you can’t develop a workable financial plan unless you have an objective in mind: (1) identify your goals – long and short-term; (2) map out a course to reach these goals, and (3) analyze your assets. Any financial plan starts with your current cash flow and your net worth.
Your cash flow is just what it says – all sources of income minus all sources of expenditures (recurring and one-time). Hopefully, the income will exceed the outgo. But if it doesn’t, it’s time to tighten the belt. If you are not planning on working after retirement, then your income will most certainly decrease after retirement. Keep in mind, when you are doing a review of your finances, every month does not have to show a positive cash flow as long as the year does. Remember if your outgo exceeds your income, there are always ways to cut the outgo.
Finally, look at your outgo and determine whether it will be fairly constant or whether the period you have examined is unique (college expenses, payment of the mortgage, medical expenses, etc.).
Next, determine your net worth. That is the figure you get by subtracting everything you owe from everything you own. List all assets – cash on hand, investments, money in the bank but also the “market” value of your house, auto, jewelry, computers and furnishings as well as the cash value of life insurance, your Thrift Savings Plan (TSP) account and vested non-government pension.
Next, list absolutely everything that you owe – mortgage, installment payments, revolving charge accounts, taxes due, and utility payments. The difference is your net worth.
Understanding Your Investment Goals
Where should you put your money so that it would be there when you need it and have earned a good rate of return? This answer depends on:
(1) how much time you have to meet your goal,
(2) your income (current and realistically projected future),
(3) your ability to tolerate risk, and
(4) what you are planning to use the money for.
There is No Perfect Investment
It is best to learn the characteristics of various types of investments and of your goals, and see what matches best.
Purpose of Investment
What are you saving/investing for? Retirement, college education for children, emergency fund, etc.. How you intend to use the money will determine what characteristics you should look for in your investments.
Time Horizon
How long before your need the money? This helps to determine the volatility you can accept in the investment and the rate of return you need to seek. If you have a short-time horizon, you need to ensure that the value of your money will be there when you need it. On the other hand, if you have a long-term horizon you want to ensure that inflation has not eroded the value of your money.
Necessary Rate of Return
Once you have done your Net Worth (you are here), set your goals (where you are trying to get to) and your Cash Flow (the vehicle) you have an idea of what rate of return you must get in order to meet your goal.
Be realistic. If an investment offers an extraordinary rate of return it will also likely carry an unusually high risk.
Your Personal Risk Level
Once you have invested your money, “Can you sleep at night?” If you worry about the return of your money and are ready to move your money at the first sign of a downturn, you probably have a low risk tolerance. But remember, every investment has some risk – if you put money in a super safe investment, a “risk free” insured account, you will have the risk that inflation will erode the purchasing power of your money.
There a five separate types of risk:
1. Financial risk: Financial risk arises because the issuers of the investment may experience financial difficulties and not be able to live up to their promises or expectations.
2. Market Risk: Market risk arises out of price fluctuations for a whole securities market, for an individual group, or for an individual security, regardless of the financial ability of the particular issuers to pay the promised or expected investment returns.
3. Interest Rate (Money Rate) Risk: Interest risk is complex and involves the price changes of existing investments because of the changes in the general level of interest rates in the capital markets.
4. Purchasing Power Risk: Purchasing power risk involves the uncertainty over the future purchasing power of the income and principal from an investment. The purchasing power of income and principal depends upon changes in the general price level (inflation) in the economy.
5. Prepayment Risk: A risk associated with the mortgage-backed securities in the F Fund. During periods of declining interest rates, homeowners may refinance their high-rate mortgages and prepay the principle. The F Fund must reinvest the cash from these prepayments in current bonds with lower interest rates, which lowers the return of the fund.