Financial Planning, Asset Allocation & Investment Strategies - Chapter 4

Financial Planning, Asset Allocation & Investment Strategies - Chapter 4

Financial planning paves the road for realizing your dreams in the future. Financial planning begins with identifying your long term goals and then setting your financial priorities. To understand the concept of financial plan, we need to be clear that financial planning is a dynamic process and keep constantly changing. Here is what you need to know about financial planning.

Key Factors That Influence Your Financial Plan

The financial plan is influenced by a number of factors like age, number of dependents, any inheritance, existing net worth, nature and cost of liabilities, your entrepreneurial plans, key macro factors etc.

How age influences your financial plan

Your risk appetite reduces with age and that means there must be a negative relation between age and equity component. The equity component formula of (100 – age) may be unsophisticated but it conveys the message nevertheless.

How arrival of a new member in the family influences the plan

When your bundle of joy arrives there is the need for setting your financial priorities. You need to factor in the long term needs of the child’s education, future security and marriage. Thus it will call for a greater proportion of equity in the investment that you are tagging the newborn’s future needs. Also expand your insurance cover.

How responsibility towards aged parents influences the plan

Nowadays, parents are independent but beyond an age it falls upon us to take greater care of parents with greater personal attention. That calls for commitment in terms of fund outflows and health insurance for them. Nowadays it is possible to get health covers up to the age of 80, albeit at a higher premium.

How entrepreneurial dreams influence your plan

For people with entrepreneurial drive, the dream is always to set up their own business. But that calls for huge sacrifices. You lose out on regular income. You take on additional debt to cater to the needs of your business. You may find it hard to meet all your expenditure and EMI commitments. This has a disproportionate impact on your financial plan.

How inflation impacts the financial plan

We plan our future based on certain assumption of inflation. Normally, the assumption of inflation is higher than the current rate. The problem arises is if the average inflation goes up by 400-500 basis points and the interest rates do not go up in tandem. That is when your plan will be left with a shortfall in terms of real returns.


9 Financial Planning Steps to Take When You Start Earning

  1. Start writing down your 5-year, 10-year and 20-year goals. If you cannot write them down today, you never will be able to do it. You may be vague, but as you write them down you will get more clarity. When do you plan to buy a car? When do you want to move into your own house? How often do you want to travel to an exotic location? How do you want to contribute for your children’s education and giving them a secure future? This is the first step.
  2. A monthly budget is the key to a sound financial future. It is easy to spend your income; it is a lot more difficult to target a level of savings and adjust your expenses accordingly. That is where budgeting comes in handy. When you budget and catalogue your expenses, you get a clear idea where are the leakages in your spending pattern.
  3. Buy insurance generously. The earlier you buy insurance, the lower your premiums. Don’t worry about over-insuring yourself. As your liabilities grow, your insurance will still appear to be inadequate. Don’t fall for high cost endowments. Focus on pure risk covers and get the maximum cover possible. Don’t forget to take health insurance early on.
  4. When you get into debt, plan to get out of it also. We live in a leveraged world. Your car and home will be obviously funded by a loan. But, personal loans and credit cards are high cost debt and you must have a time-bound plan and the liquidity provision to defray these loans. The time you start earning is the time to initiate such plans.
  5. Build an emergency liquid fund to cover at least 5-6 months of expenses. You could lose your job, you could venture into a business, or you could fall ill; anything is possible. Use your early days to set aside the emergency fund and invest in a liquid fund so that it is liquid and also at the same time, prolific.
  6. You have already written down your goals; now create a plan around them. Sit down with your advisor and work out your investment targets. Decide upon your asset mix and how to save and invest to achieve these targets. The earlier you start your financial plan the power of compounding works in your favour.
  7. Start creating a nest egg for yourself. If you think that 24 years is too early to plan retirement, think again. With increasing life spans, you need to plan a longer post-retirement life. Ensure that you are adequately provided for. The earlier you start; the better off you will be post-retirement.
  8. Maintain a good and steady CIBIL score as it is the key to your creditworthiness. Don’t overstretch on credit and avoid high cost debt. When you take a loan ensure prompt EMI repayments as that will enhance your credit score. Don’t avoid credit because zero credit history is also a negative factor.
  9. Documentation is an important aspect of financial planning. This sounds hackneyed but is an important task. Ensure that all your plans, your documents, your certificates, statements, tax returns and financial plan are elaborately documented and filed. Create an online/offline filing and back-up system.

It is always best and the most productive to embark on financial planning early on in life.


Outlining Short Term and Long Term Goals in Financial Planning

When we embark on financial planning, our primary task is to clearly define our goals in financial terms. What is equally important is the classification of short term and long term. Short term goals are those which are maturing in the next 3 to 5 years. Goals with a time frame of 5-10 years are medium term goals and those goals which will mature beyond 10 years are referred to as long term goals. This classification is important because your asset mix and your liquidity management strategy will be determined by whether the goal is short term, medium term or long term.

Managing Short term and long term goals in financial planning

Financial planning for short term and long term goals differ in terms of short term vs long term investment.

  • Your risk appetite differs based on classification of short term versus long term goals. If the goal is maturing in 3 years there is only limited risk that you can take. Equities can generate wealth but they are not guaranteed to generate within a time frame of 3 years. When it comes to long term goals, you can afford to absorb greater risk.
  • It is a key determinant of your asset mix. If your specified goal is maturing in 3 years you need to be largely in a debt portfolio with a small portion in equities. On the other hand if your goal is maturing in the next 15 years then you have the luxury of having a bigger allocation to equities.
  • The power of compounding can be better leveraged in case of long term goals as compared to short term goals. Check the table below…


3-year SIP


15-year SIP

Monthly SIP


Monthly SIP


No. of Months

36 Months

No. of Months

180 Months

Annualized Yield


Annualized Yield


Total Investment


Total Investment


Cumulative Value


Cumulative Value


Cumulating Factor

1.27 times

Cumulating Factor

3.76 times


The power of compounding works better over longer time frames. This makes it possible to create more wealth in the long run.

  • Finally, there is the aspect of liquidity shift that happens much earlier in case of short term goals. A liquidity shift refers to converting your risky positions into risk-free positions gradually ahead of the milestone date to avoid unnecessary surprises.

The demarcation of short term and long term goals lies at the core of financial planning as it helps you to clearly demarcate your goal and your investment mix accordingly.


How to Check If the Financial Plan Is Flexible

It important to have a flexible financial plan that adapts to change. Here is a quick rundown on what exactly can you classify as a flexible financial plan?

  1. Does it account for change in income levels? The drawback with most financial plans is that they assume constant SIP outflows. But, your income does not remain constant over time. In fact, your income normally follows an upward trajectory and therefore your financial plan must follow suit.
  2. Does it account for changes in life style? Retirement goals are determined by inflating our current costs at inflation. However, our life style does not remain the same with higher income levels. Your financial plan must be flexible to adapt to the higher monthly requirements in the future and build it in.
  3. How will the plan handle major economic disruptions? We have seen major economic disruptions like economic liberalization, shifts in interest rate trajectory and shifts in inflation trajectory. These also impact the value of long term goals. Ensure that the plan is flexible enough to incorporate these major shifts
  4. Is the plan inflation efficient? Inflation works both ways. When inflation goes up it changes your future fund requirements and reduces the present value of your future investments. When inflation goes down, it increases your real income but it is often a harbinger of economic slowdown. Adapt accordingly.
  5. Has the plan provided for the peripheral risks? Peripheral risks arise in a variety of ways. You need health insurance to ensure that medical emergencies do not become a crisis. Your loans need to be insured so that your assets are not impacted. Above all, your physical assets need to be insured as part of your long term goals.
  6. Can the plan accommodate goal changes and goal shifts? At a simple level, your goal milestones may change. You can have an addition to your family and that means two sets of goals. Alternatively, your parents may come to depend on you for financial support and you need to stand up for them.
  7. Does the plan have a rule-based auto monitoring system? Every financial plan must have an in-built auto monitoring system. For example, shift in allocation between equity and debt must not only be age based or goal based but also asset class return based.
  8. Can the plan accommodate changes in tax implications? In Budget 2018, the government introduced 10% tax on long term capital gains on equity funds. Over a 15 year period, nearly 80% of your wealth creation will come from capital gains. Your financial plan needs to be flexible enough for that.
  9. How is the plan equipped to handle individual setbacks? This is a slightly more delicate and personal side of financial planning flexibility. For example, you create a financial plan for the long term assuming that everything will be fine over the next 20 years. But, that may not be the case. You could lose your job or you may choose to give up your job and start a business on your own. If your business faces the initial 5-year blues, then it can seriously impact your financial plan.


Flexibility of your financial plan ensures its sustainability. That is why it becomes so critical!



A financial plan is a systematic method of assessing your goals, assessing your resources, projecting your inflows and then squeezing corners to meet the gap. If that sounds too simplistic, it is not! The process of financial planning is quite complex and calls for an interplay of goals, investments, returns and risk. Here are the common financial planning mistakes to avoid as they can be detrimental to long term wealth creation.

Delaying the start of your financial plan

Financial planning is all about making time work in your favour. The longer you invest, the more your principal earns returns and therefore the more your returns earn further returns. In technical jargon it is called the power of compounding. Starting your financial plan 5 years late can make a big difference to our eventual corpus and your monthly outlays required. When you start early, you start accumulating a corpus early and that gives you greater leeway to make appropriate changes to your plan as you go along. If you start too late, you simply lose that flexibility.

Focusing on endowments instead of term insurance

Your insurance sales agent is very keen to sell you an endowment policy and he sells it to you as a combination of insurance and investment. You must not buy that idea. Remember, your insurance needs and your investment needs must be kept separate. When you insure be willing to write off the premium. So prefer term plans to the extent possible. Instead of getting stuck in endowments, invest the premium saved in mutual funds.

Going for inadequate insurance cover

This typically applies to life cover and health cover. How do you decide your life cover? Take an example. If your monthly expense is Rs.75,000, then your family will still require that amount on a monthly basis in your absence. To earn Rs.75,000 per month you need to earn Rs.9 lakhs per year. You cannot take the risk of volatility and illiquidity so it is best you are invested in liquid funds. Liquid funds give you 6% returns on an average so your family will need a corpus of Rs.1.50 crore on hand. Then there are liabilities that need to be closed so you must be looking at a term cover of at least Rs.2 crore. In health insurance it is fine to take Rs.5 lakh cover for each member but in case of family floater, let it be higher.


Not saving enough at an early stage

To invest you first need to save money. The mistake most people make is to treat savings as a residual item after spending to one’s heart content. Actually it should be the other way round. Expenditure should be a residual item after meeting your savings target. Try doing it that way and you will be surprised to see how much you save at an early age.


Not taking enough risk when you can afford it

AT the end of the day returns are always a trade-off against risk. If you want to create a corpus over 25-30 years then it is ridiculous to be predominantly invested in debt. Over such long periods, equity funds have given great returns with negligible risk. Your risk need to be calibrated. When you can actually afford to take risk, you have to take calculated risks. Otherwise, you are never going to create wealth through debt alone.


Ignoring the impact of inflation in financial planning

Inflation is considered to be the thief of value, and not without reason. When inflation is 8% then Rs.108 that you will receive after 1 year will only be worth Rs.100 today. That means, your monthly SIP must be growing at least above the rate of inflation. If the annual inflation is 6% then your annual accretion to SIPs must be at least going up by 10% each year. Otherwise you will never be able to beat inflation.


Spending too much money servicing your debt

If you have money and you have a lot of high cost debt like credit cards and personal loans, then what should you do. The answer is simple! Just focus on repaying your high cost loans first. You pay 37% annual interest on your credit. When you close your credit you are virtually earning 37% annually. There really cannot be a better investment. Use intermittent cash flows judiciously to repay debt. You will also save yourself from financial risk.


Choosing MF dividend plans instead of growth plans

This is a cardinal blunder a lot of people commit. When you invest in MF growth plans the compounding takes place automatically. On the other hand, if you opt for dividend plans then you have to reinvest the dividends received. That never happens in practice and therefore it impacts your final wealth count. Ideally prefer growth plans as they are all about automatic compounding of wealth.


Ignoring the impact of taxes

Taxes make a big difference to your effective returns. When you earn dividends or capital gains there is a 10% tax under specific conditions. However, if you earn interest on bonds then the returns are taxable at your peak rate. When you chart out your plan always look at its effectiveness in post tax terms.


Creating number of parallel plans

Finally, we all make the mistakes of parallel plans. There is a college plan, a financial plan, a tax plan etc. That is not the right way. Have one master financial plan. Everything else just becomes a subset of the master financial plan. That includes your tax plan too!


Understand What Asset Allocation Is All About

Asset allocation is frequently used yet most commonly misunderstood. Essentially asset allocation is an investment strategy. Asset allocation has 3 steps.

  • Firstly, you assess the returns and risks of each investment option available like equity, debt, hybrids, gold etc.
  • Secondly, you evaluate the relevance of each of these asset classes depending on your specific return requirements, risk appetite, tax status and liquidity needs.
  • Lastly, you actually decide on the distribution to various asset classes. That is what asset allocation is all about.

Four essential facts about asset allocation

  • Your asset universe must be broad and flexible to accommodate new investment ideas. For example, equity, debt and gold are the time-tested investments. But newer products like alternatives, structured products and hybrids are great ideas to make your financial plan more tuned.
  • How many assets do you want to spread yourself across? The thumb rule is that your spread should be dependent on the corpus that you are targeting. With a small corpus it is best to stick to just debt and equity. Other asset classes will begin to make sense if your corpus is much bigger.
  • Ensure that asset allocation is well diversified. If you have 4 asset classes and all are going to react negatively to a hike in the US Fed rates, then you are thematically not diversified. Your diversification should be across asset classes, time classes and also across theme sensitivity.
  • Finally, seek expert help in the asset allocation process. Despite the availability of algos and robo advisors there is nothing like a human touch to your financial future. Therefore it always makes a lot more sense to get an expert to advise you and assist you in the process of asset allocation.


Different Approaches to Asset Allocation

Broadly, there 5 approaches that can be adopted with respect to asset allocation!

  • Strategic asset allocation is based on return expectations. For example, if your annual return expectation is 12%, then you will decide your mix based on the historical returns earned by equity and debt. This needs to be constantly tweaked but expected returns will be the driving factor.
  • Constant-Weight asset allocation focuses on maintaining a pre-determined weight to equity, debt and hybrids based on risk perception. Each asset class is given a leeway of around 5% and once that is breached then the asset allocation is brought back to the original level. This is a relatively more disciplined approach.
  • Tactical asset allocation is more active compared to a constant weight approach. In tactical asset allocation, you maintain a broad benchmark allocation to various asset classes but retain the flexibility to sharply increase or decrease the allocation based on your view.
  • Dynamic asset allocation is a more aggressive form of tactical asset allocation. The revision of asset mix based on your asset class view is more frequent and more aggressive. However, too much churning entails a higher cost in terms of transactions costs, statutory costs and capital gains tax.
  • Insured-asset allocation is an active risk management approach wherein you will not permit the value of the portfolio to fall below the base value. In that case, the entire corpus will be invested in risk-free assets. Normally, such an approach also entails the use of beta hedging using futures and options.


How to Do Asset Allocation Using Mutual Funds

If you think that asset allocation appears to be complex, then mutual funds could actually offer you the answer. You have a really wide spread. Within the gamut of equity funds you have diversified funds, sectoral funds, thematic funds and ELSS funds. Within the gamut of debt funds you have liquid funds, liquid-plus funds, MIPs, corporate debt funds, G-Sec funds and income funds. Within hybrid funds you have balanced funds, MIPs and dynamic allocation funds. To add it, if you want to get passive in your allocation then you have index funds, index ETFs, gold ETFs etc. In a nutshell, MFs can offer you the entire process of asset allocation on a platter. The added advantage of mutual funds is that since you can structure SIPs on any of these funds, you get the added benefit of rupee cost averaging.


Importance of Asset Allocation in Your Financial Plan

You start financial planning with your goals in mind. Then you work backwards and work out a plan to achieve these goals. You cannot achieve your long term financial goals by just saving in a bank savings account. What you need to do is allocate funds to risky investments and take calculated risks. That is the way to ensure that your principal earns returns and your returns also earn returns over a period of time.

So what is the importance of asset allocation in financial planning? When it comes to financial planning, asset allocation has a very major role to play.

Understanding aggressive versus conservative asset allocation

Asset allocation is about implementing an investment strategy that balances risk and returns. An allocation with a higher exposure to equity is a more aggressive strategy while an allocation with a higher exposure to debt is a conservative strategy.



As can be seen from the above two pie charts, the aggressive portfolio has a much higher allocation to equity while the conservative portfolio has a much higher allocation to debt. Normally, an aggressive portfolio tends to yield much more compared to a defensive portfolio in terms of wealth creation over the longer period of time. However, the returns on an aggressive portfolio can be quite volatile over shorter time frames. Here is why asset allocation matters to your financial plan.


Importance of asset allocation in your financial plan

Asset allocation lays out a broad plan for achieving your long term goals. There are 5 reasons why asset allocation is important to your financial plan.

  1. Asset allocation translates risk appetite into an actionable percentage allocation to asset classes. As we have seen in the asset allocation chart previously, an aggressive allocation has a greater allocation to equities compared to a conservative allocation.
  2. The asset allocation focuses on risks you can afford to take. If you take more risk than you can afford then your portfolio is exposed. If you take less risk than you can afford you get sub-optimal allocation which will result in lower than expected returns.
  3. The asset allocation defines a pathway. As you age your exposure to debt has to increase. As you approach goal milestones, shift a greater portion to liquids. This kind of granular planning is only possible through asset allocation.
  4. Asset allocation tracks the sensitivity of your portfolio to external factors. What happens if inflation goes up by 200 basis points or what happens if interest rates fall by 200 basis points? These questions can only be answered by asset allocation.
  5. Asset allocation over a longer time frame helps you to clearly define your cost of financial planning. When you plan your finances, there is a cost in terms of transaction costs, statutory costs and switching costs. All these can be clearly demarcated to judge the effectiveness of your financial plan in net effective terms.


Difference between Financial Planning and Asset Allocation

The terms financial planning and asset allocation are normally used interchangeably. Actually asset allocation is a part of financial planning. The financial plan lays down the broad goals and how you want to move towards it. Asset allocation is more the action plan towards your financial plan.

Financial planning is the “Where” and “What”

Before understanding the “Where” and the “What”, let us lay  the 5 key elements to financial planning.

  • It begins with a comprehensive evaluation of your current situation. What is your income, expenditure and your surplus? It also looks at what are your current assets and liabilities and what is your net worth at this point of time.
  • The second step is where you want to reach. This is all about financial goals. You may want a car in 2 years and an apartment in 5 years. You need to plan for that. You may want to go on a foreign holiday after 3 years and that also requires planning. Then there are the long term goals like child’s education and your retirement.
  • The third step is to work backwards and estimate the risks to the plan. There is the risk to life; there is risk to property and the risk to your health. These are risks that need to be insured. You need adequate insurance to ensure that your family is taken care of in your absence and your long term goals are not impacted.
  • Now you need to work out how much you will need and then calculate the present value of these goals. Then you plan your SIPs in such a way that you have a high probability of reaching these goals. This step will actually form the basis of your asset allocation which we will deal in greater detail.
  • Finally, you must conduct a sensitivity analysis which will become the basis for monitoring your financial plan. Your plan must be constantly evaluated and monitored based on some specific parameters. This will give you a clear idea of whether you are on track or not and what curative steps are required to put the financial plan back on track.

The “How” of Asset Allocation

If financial planning is the “Where” and “What” of your finances, asset allocation is all about the “How”. How do you go about allocating assets so that you can reach your financial goals; that is what asset allocation is all about! Here is what you must know about the process of asset allocation.

  • In financial planning you do not get into asset specifics. Ideally, you plan through equity mutual funds which are relatively passive compared to direct equities. So what does asset allocation cover? Asset allocation is all about the mix of various classes of assets available.
  • Asset allocation actually lays out your broad mix of asset classes. For example you need to decide your mix of equities, debt, liquidity, gold and commodities. The percentage allocation will be worked backward based on the goals defined in the financial plan.
  • Asset allocation is not only about returns but also about risk, tax efficiency and liquidity considerations. That means you either maximize returns for a given level of risk or you minimize risk for a given level of returns. At the end of the day, the success of the asset allocation will be also judged based on how well it manages the tax aspect and how smoothly the liquidity was made available.

Once the asset allocation is completed then you actually get down to the task of identifying specific instruments to invest in with a view  to meeting your long term and medium term goals.