Monday, May 14, 2012

Financial Planning for the Young Professional - Part 1

You have just completed college and have landed this new job that you have always wanted. And now you are all set to enjoy your new found financial independence. It is only natural that when you receive your first pay check, you want to buy all those cool gadgets and go on a shopping spree buying all that you have always wanted. It is only when the financial year is about to close and when you have to submit documents related to your tax planning & tax saving investments, that most young people seriously think about investing. And from what I have seen, young people google the top mutual funds or invest their money in to some ULIP (Unit Linked Insurance Plan) which their relative/friend or the salesman from their bank 'suggests' to them. This last minute investment rarely works out well since you don't have the time to research and the objective of your investment was to save some money as tax!

The most important thing a young professional should keep in his/her mind is that there are two objectives while investing - 1. To save for a rainy day and  2. To grow your savings so that you have a comfortable kitty when you decide to retire or when you need to make withdrawals from your investment kitty for some major expenses. Saving and Investing are not essentially the same thing. There is a major difference between Saving and Investing, which I had explained in an earlier post. Everyone agrees that it is necessary to invest. But when you are  young, things like retirement, children's education and all such future expenses look so far away that you don't really think much about them. However it is very important that you start early. 

The first step to investing is to create your financial plan. No, you needn't pay a lot of money to get 'Wealth Management' services and you can do this with a piece of paper, pen and a calculator (or an excel sheet). As I had mentioned in a previous article (6 Steps of Financial Planning), you need to write down (yes you need to actually list down & not simply run them through your head) you future needs and financial goals. Then you need to set a time line i.e. think 'when do I need to achieve these goals and how much would I need'. Once you have an idea on how much money you would need, you can now think about putting that much money aside. Take a decision to save this amount every month. 

You have a lot of investment options in the market but stick to the ones that are easy to understand. Do not invest in 'schemes' and complex financial products. I heard of a product which involves a zero coupon bond and nifty options combined to form an instrument where depending on your age and risk profile, money is allocated to to the bond and options. Ask yourself - Would you be comfortable with a product like this? My advice is to avoid exotic products as much as possible.

This article is divided into 2 posts: In part 1 of the article I shall talk about the often neglected but the very important financial instrument - Insurance. In part 2 I shall deal with Equity and Fixed Income Investments.


Before you even start thinking about investments, you need to first think about protecting your current and future financial condition. When people are young, they are filled with bursting optimism about life and nobody thinks of insurance at all. But as you grow older, the premiums increase for life insurance, so it is wise to plan this before hand. 

But how much Insurance do you need? The first step towards calculation of Human Life Value would be to determine the net annual income of the person after deducting the amount spent by him for his personal use. This amount will be the amount that he affords to his family annually.For Example, Mr. Vinu, aged 28 years, earns  12,00,000 per annum and spends  4,50,000 per annum on himself. Hence, he earns a net income of  7,50,000 p.a. for his family. Therefore, as income replacement, his family would require  7,50,000 p.a. for 1 year of life expenses. Each year, with inflation, the family's expenses would proportionately increase, which must also be taken into account.He must also include any specific goals like children's education, marriage etc into account. 

I shall briefly discuss the different popular Insurance products available and whether you should take them or not. 

i) Term Insurance: This is a pure investment product and works in a very simple way. You select a sum insured (say Rs 5 million (50 Lakhs)) and pay an annual premium for a term you select (say 25 years). In case you meet with an untimely death during this term, your family receives the sum insured. In case you survive this term, you do not get anything. A lot of people think that since they do not get back anything, this is not a good place to put their money in. However, the reason you pay the premium is for protection. And you get this protection at a cheap rate. At the time of writing, a Rs 50 lakh cover was available at just Rs 5000 per year i.e. less than Rs 420 per month! The objective of insurance is protection and please remember this. A term insurance is the best product you can take and if you have family members dependant on you, then you must take this. Click here to read more on Term Insurance.

ii) Endowment Policies: An endowment policy covers risk for a specified period, at the end of which the sum assured is paid back to the policyholder, along with the bonus accumulated during the term of the policy. The returns on endowment policies are typically very low - approximately 3% to 4% per annum - and often do not beat inflation. (Click here to read more about Endowment policies)

iii) Unit Linked Insurance Plans: These are insurance policies with an investment component. In these policies, the policy holder pays regular premiums (or a single premium) of which part of the money is invested and another part goes towards providing the life insurance cover. Though it sounds good, a ULIP rarely does justice to either investment or protection. ULIPs have a high entry loads and exit loads and brokers aggressively mis-sell these products due to the high commissions they get.

It is recommended to always opt for a pure insurance product rather than combining insurance with investments and I would strongly suggest to opt for a term plan only.

In my next article, I shall talk about the investment options - both equity and fixed instruments available for  the young professional.

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