Two Pillars of Personal Finance

There are two pillars of personal finance.  Wealth Accumulation and Wealth Preservation. Wealth accumulation is about taking steps to accumulate money for your financial goals. Wealth preservation ensures that your accumulated corpus does not take a significant hit in case of any unforeseen event and you stay on track.

Personal Finance is Personal

There is no one size fits all solution when it comes to personal finance.  What may be a perfect investment for your neighbor may be strictly avoidable for you. For instance, investment and insurance portfolio and a 25 year old and a 60 year old should be vastly different. A 25 year old should have an equity heavy portfolio while a 60 year old should have a portfolio that is geared towards debt products. You don’t need life insurance once you have retired and are no longer earning.

Even two 25 year olds can be recommended two entirely different investment products based on their requirements. You might be saving money for higher education 2 years later or for your retirement. The product recommendation will be completely different in these two cases.

So, do not rush to invest in a particular product just because your friends are investing there. Try to understand if the product suits your requirement.

There is another important aspect of personal finance i.e. estate and succession planning. This helps avoid disputes in the family after your demise. Such aspects have not been covered in this post. Moreover, once you retire, wealth accumulation is replaced partially wealth decumulation i.e. using accumulated wealth to generate regular retirement income. I won’t discuss wealth decumulation in this post.

Wealth Accumulation

You accumulate wealth by investing your money in different investment products. The choice of investment product depends upon multiple aspects such as your risk profile and the investment horizon. Your risk profile is determined by your ability to take risk and your comfort with risky investments. Age is one of the parameters that determine your risk profile. Your risk taking ability decreases with age.  At 25, you can afford to take more risk since you have many years of earning ahead of you.  The same cannot be said when you are 60. Here are a few things you must keep in mind when it comes to wealth accumulation

1. Decide your financial goals: Without financial goals, it is like shooting in the dark. Crisp targets help you maintain investment discipline and even do course correction, if required. Most of us tend to settle for randomly high numbers for everything, Rs 20 lacs for child education in 10 years, Rs 2 crores for retirement. No rationale but just a big wild guess. This approach won’t do. Seek professional help if required.
2. Get the asset allocation right: Diversify across asset classes. Excess of anything is bad. In my opinion, asset allocation is more important than investment product selection. Seek professional help if required.
3. Purchase a house to live in: Not every decision that involves money can be solved on an excel sheet. An own house gives a deep sense of comfort and financial security to the family. However, avoid paying through the nose for the house. Affordability is the key.
4. Invest in equity heavy portfolio for long term goals: To me, long term is at least 7-10 years. Unless you are extremely confident about stock picking and can research on your own, stick to equity mutual funds. Invest through SIPs in direct plans of mutual funds. Acting on stock tips is a recipe for disaster.
5. Invest in debt heavy portfolio for short term goals: Suited for goals which are up to 5-7 years away. Stick to high quality debt products such as fixed deposits and good credit quality debt funds. Do not take undue risk for 0.5-1% of extra interest. There are a few debt products such as EPF and PPF, which can be used for long term goals too.

Most people, I talk to, have begun to realize the power of compounding, benefits of starting early and sticking to investment discipline. They understand the power of small but regular investments. However, I find the very same people woefully short in financial planning when it comes to wealth preservation. What perplexes me is not that they have not purchased adequate insurance but that they are not even thinking about it and do not understand its importance either. A lot of people consider insurance products a waste of money. 

What does this approach lead to?

1. Inadequate life insurance and low returns: You end up purchasing products that provide the dual benefit of insurance and investment such as Unit Linked Insurance Plans (ULIPs) and traditional insurance plans. Though you can still make case of purchasing certain types of ULIPs (type-II), traditional life insurance plans (endowment, money back plans) must be STRICTLY AVOIDED.  Traditional life insurance plans provide inadequate coverage and abysmally low returns.  In my opinion, insurance and investment shall never be mixed. In these dual products, the life cover is linked to the premium amount you pay. Hence, your ability to pay premium restricts your life cover amount. Your life insurance requirement does not depend on your ability to pay premium.
2. Leave your finances highly suspectible to emergency: You rely solely on group health insurance cover provided by your employer to meet your hospitalization expenses. Employer covers have multiple restrictions and you can be left without cover during job switch, retirement or loss of employment. In any case, a cover of Rs 3 lacs for a family of 4 in Mumbai is never going to be enough.

What is Wealth Preservation?

Through wealth preservation means, you ensure that your accumulated wealth does not get wiped off in cases of emergency. This can easily happen in case of a prolonged hospitalization. Hence, over the long term, wealth preservation is as important as wealth accumulation.

What are the steps you need to take to preserve wealth?

1. Build an emergency corpus up to 6 months of expenses: This is helpful in case of loss of employment and any emergency, financial or medical. Please your health insurance does not cover all kinds of hospitalization. You will have to shell some money from your pocket.
2. Purchase adequate health insurance: This ensures that you don’t have to dip into your investments in case of hospitalization of any of the family members.
3. Purchase adequate life insurance: To find out about how much life insurance you need, please go through this post. Do not mix insurance and investment. Stay away from traditional plans. Purchase only term insurance.
4. Purchase adequate disability coverage: Personal accident and disability covers fill an insurance gap in your portfolio. You can purchase this as rider to your existing insurance plan or as a separate personal accident insurance plan. These are not very expensive either.

Life insurance and disability covers can also be considered wealth accumulation tools in some sense. These insurance plans help bridge the gap between your existing net worth and the amount required for your financial goals.

Always remember Personal Finance is “Personal”. And yes, merely passing assets to your family won’t do. You need to educate them too about personal finance.

Image Credit: Simon Cunningham, 2013. The original image and information about usage rights can be downloaded from Flickr/Lendingmemo

Deepesh is a SEBI registered Investment Adviser and Founder, PersonalFinancePlan.in