Why you should have a financial plan

Having a clear financial plan is core for taking control of your finances. Ironically though, not many people pay close attention to this. Not even people who seemingly are on top of their game as far as their spending and investing choices are concerned, get around to documenting a proper financial plan. Hence, it’s not surprising they fall off the wagon quite easily.

The precursor to personal financial management is a well-structured financial plan.

A financial plan helps you outline where you want be with your money, what you need to do, when you need to do them and how you need to do them. It provides an overall framework for directing the flow of resources which encompasses all the different goals you might have from time to time. Thus, creating a path and timeline for you to follow towards achieving your goals.

It also helps to prepare for big life events – birth of a child, purchase of a family home or children’s college education. These require more than just saving; they require a detailed financial plan that consists of the following – sorting out debt, planning and tracking expenses, setting financial goals, building an investment portfolio, arranging insurance and the constantly reviewing the plan.

The financial plan is clearly personal and would vary from one individual to another. They also need to reflect changes that might occur in the various stages of life.

Keep an eye on your debt

In Nigeria, we don’t really have student loans and the use of credit cards hasn’t quite caught on. So not many people are faced with the kind of debt issues we hear about from western countries. However, in the last few years, we have seen a large number of payday loan providers spring up. These institutions offer unsecured loans to salary earners at rather high interest rates.

Often, the question is which do I do first, save or pay off debts? The simple answer to that is, it depends.

Clearly, if you have a high interest loan, then you should focus on paying it off. And the reason is quite simple, there is hardly any investment product out there that can generate sufficient returns to outpace the interest due on those high interest loans. For example, if you have NGN500,000 in Savings (at 3 percent per annum) and NGN500,000 in loans (at 25 percent per annum). You clearly need to pay down your debt, as doing otherwise is like investing NGN500,000 and knowing for sure that you will be losing 22 percent per annum.

Be that as it may, you probably need to be doing both where you can. What do you do when an emergency occurs and you have channeled all your earnings into paying existing loans? You probably have to take on more debt, and debt becomes a revolving door.

Hence, an ideal solution is one that gives you the best of both worlds. This would involve putting some money aside to cover sudden emergencies and paying the maximum possible to reduce your loan amount. Once, you have built your emergency saving to cover at least 6-months of living expense, you can then get more aggressive in dealing with your debt (particularly high interest loans).

The Magic of Compound Interest

Compounding is described as the eighth wonder of the world and/or man’s greatest invention, compound interest is the silver bullet for growing your money. According to Benjamin Franklin, this is the best way he knew how to get rich.

Simply put, compounding means earning additional interest income on already earned interest income. It is the snowball effect that happens when your earnings generate even more earnings.

In other words, for every additional period you help your investment, you will earn interest not only on the principal but you will earn additional interest on the interest that was earned in the prior period. As a result even if the yield on your investment stayed constant, your money would keep growing at an ever increasing rate.

Say for example, on your 20th birthday you are gifted N100k below are 3 scenarios you could end up with on your 50th.

  • If you kept it under your bed, you will still have a nominal N100k but inflation would have eaten deeply into it.
  • If you invested it at 8% yield and didn’t reinvest the interest, you will still have N100k but have earned N400k over those 30 years.
  • If you invested it at 8% and reinvested all your interest, you will have grown your stash to N1.01m

The above clearly demonstrates the impact of compounding.

Clearly, the interest rate you earn on your investment as well as the length of time you have to hold the investment would have big consequences for the final outcome of your investment portfolio

Now imagine if you took it a step further and added N20k to investment every year, your nest egg would have grown substantially to N3.27m.

Why i should have bought a Japanese Car

Though so many things are wrong with the educational system in Nigeria, with how important money and finances are to most of us, I wonder how come we don’t have a great deal of financial education in the curriculum.

Quite alright, we covered some topics in business studies class in junior secondary, but really though, it would be good if we were taught how to invest, handle our pensions etc.

And the result of this deficiency is quite evident.

Even I as a person, in spite of my economics degree, graduate degree in finance is still made some big blunders. When I got my first job back in Nigeria, I did not open a pension account, so I missed out on employer contribution to my pension, that was me literally throwing free money away covering my eyes. One reason why I didn’t open a retirement savings account was, I didn’t think I was going to be in the organisation for a long time, so why waste my time filling some forms (oh! I hate forms) and in my mind retirement wasn’t something for me to be bothered with at that stage of my life.

Don’t get wrong, my certification wasn’t purchased, I actually passed my qualification exams.

So I knew about investments and was saving about a third of my salary every month. I also expected the Naira to weaken, so I started buying into a USD funds more than 3-years before the depreciation eventually happened.

But I could have done way more as I was living with my parents. Though I wasn’t giving to partying and clubbing, I loved fine dining, so I spent quite a bit doing restaurant crawls.

I also made some interesting choices when I wanted to buy a car. I loved German cars, so I went and bought a Passat. In hind sight I probably shouldn’t have. No doubt, the car was German engineering in its purest form but the cost of servicing the car is about 3/4-times what it would have been if had just respected myself and bought a Japanese car.

Anyway, I have since gotten my act together as much as I can. I have my emergency fund sorted out, I started an investment club with some old school mates, still hold my USD funds and have grown those, and gradually growing my stock portfolio as well as continuously investing in a mutual fund (I actually started this during NYSC). And most importantly, I have my Retirement Savings account sorted now (by the way, my Pension Fund Administrator had the second best return in 2017).

Though things are on the right path now, I wonder how different things would be without the false start and the wrong moves.

I am a second generation stockbroker (i.e. my dad is also a stockbroker) and all through my life encounters with friends have mostly ended up with discussions about investments. Often, they are not asking questions that indicate they want to move their portfolio to the next level, the questions often give them up as complete novices with regards to investments and personal financial management. Also, what I have found is that just a very small percentage of young people own shares or mutual funds, most of their funds are in savings accounts and in government treasury bills, at best (i.e. those that have some savings).

This couple with the unemployment problem, means most young people are basically ‘ninjas’ i.e. no income, no job and no assets. For the most part, this is due to no fault of theirs. They just don’t know better.

Tying this all up, financial literacy is of enormous importance to society and this failing of the educational system hurts us all.

If I knew better, I would have done better and I believe same applies to every young person out there. Hence, I started this blog to help you people discover the art and science of investing. And it’s not just about growing your bank balance or swelling your investment account but about freedom – ability to do/buy whatever you want, go wherever you want and whenever you want, without the fear of going broke or not having enough money to sustain you in retirement.

Know Your Numbers

Every journey begins with the traveler identifying her current location and from there planning the best route to their destination. In the same vein, if you are seeking financial security, accessing your current financial situation is the starting point.

This entails two things – knowing what you own and what you owe as well as knowing where the money comes from and where it goes. The former can be liked to a balance sheet while the latter can be equated with an income/expense statement.

Estimating your net worth entails the computation of the value of all your assets – cash, bank balances, property, jewelry and then subtracting from it all liabilities – credit card debts, car loans. In computing the value of your asset, its best to estimate them using how much you could realize from them in the event of a forced sale. With this information you will have an idea of what you have left after selling all your assets and paying off all debt and you can track your progress from year to another.

The second aspect is understanding your cash flow. On one hand, you list income from all sources – salaries, bonuses, gifts, dividend etc. And then the most important part, tracking your expenses along the following major headlines – saving, investing, giving and spending. With this information, you can have a bird’s eye view of where your resources are going.

 

Pay Yourself First

Typically, when most people get their paycheck they start by settling overdrafts and then go on to pay bills and then to buying groceries and other consumables. And then they save if there is anything left. There lies the problem, because human wants and needs are unlimited, often they are left with next to nothing to save.

If however, you chose to save first and get that out of the way, you will find ingenious ways to deal with the bills (cutting out unnecessary stuff).

How is it that every month, you pay the baker of your bread, your hairdresser etc.? But you who did all the hard work to earn the money in the first instance get to keep nothing of all that hard work.

I guess it’s for the same reason, the government takes their taxes out of your salary, even before it gets in to your hand. In the same vein, set up a ‘me tax’ with any proportion that you deem fit, subject to a minimum of 10% no matter how little you earn (ideally you should aim for 20-30%).

To someone on the minimum wage, that probably sounds unrealistic. Your income is barely enough to keep the lights, then imagine what happens if you took some money out for savings. However, we humans have a great capacity to adapt to situations. Surely, there are people who get by with less than what you earn.

Be that as it may, even if you can only pay yourself a small amount now (say 5%), that’s still a good place to start, but be on the lookout for opportunities to increase your ‘me tax’ in the future. Also, setting up a direct debit from your salary account into your savings account on pay day makes this process seamless.

Once this habit sets in, you would be armed with the seed to start putting that money to work.

Build your Emergency Savings

Once you start investing you would realize that the markets can swing wildly and without a stash of cash to cover during an emergency, you could be forced to exit your investments in a down market. Hence, the need to have an emergency savings fund.

Also, all investments involve some risk of losing some or all of the invested amount. However, knowing you have some money set aside to cover in the event of an emergency would give you the confidence to take such calculated risks.

Furthermore, it helps improve overall financial security, as you don’t want to lose your job or suffer a debilitating illness and have to take out expensive loans to tide your family through the tough times. Hence, the need to have some money set aside to cover in the event of financial surprises life throws your way.

Experts differ on the exact amount that you should have in you emergency savings and for good reason. The amount required by people in a weak economy or industries prone to layoffs would differ from those in a strong economy and relative job security. It would also differ depending on the size of your family.

However, most experts recommend having enough money to cover 3-6 months of living expenses (housing, feeding, healthcare, utilities, transportation, personal expenses and school fees, excluding entertainment and nonessential shopping).

Should this funds just sit in a savings account, waiting for an eventuality, definitely not? Money market funds are great place to hold your emergency savings because they are easily accessible and pay higher returns than a regular savings account.