This post is in response to the query that I got from a friend who read my post on Investment Books for Beginners. He wanted guidelines for managing his own finances.
My friend is an IT professional who after a few years of job decided to manage his finances. He read about financial planning online and hired services of a financial adviser. He is not satisfied with the adviser and decided that he needs to take charge of his investments. It is the right decision. The earlier taken the better.
This post outlines a basic approach to financial planning for a young person in his/her initial stages of career who is a naive in finance until now.
Insurance is the first thing one should have. It includes accident, health and life insurance. Please do not confuse insurance with investment. Keep it simple and pure insurance. We would discuss investments later.
I think it is the first insurance each one of us should buy. It becomes useful if you meet some accident and suffer serious injuries. There are multiple coverages offered by different insurers. One should focus at Accidental Death, Permanent Total Disability and Permanent Partial Disability.
What is the sufficient cover amount? There are diverse views. I believe that the cover amount should be such that when invested in bank fixed deposits (FD), it should replace your current salary. If your monthly income is Rs. 20,000 then you need Rs. 240,000 as annual income from insurance amount. Considering SBI FD interest rate of 8.50%, you would need Rs. 28,23,529 to replace your current salary. This cover amount is about 140 times your monthly salary.
Many general insurance companies offer accident insurance but most of them put a limit on maximum cover from paltry 500,000/- to 25,00,000/- or about 24 times of monthly salary. I find Apollo Munich and Tata AIG as good ones. They are reputed insurers who provide you with higher cover options at competitive premiums.
As you grow old, responsibilities & earning power increase and accordingly you should keep increasing the cover amount by upgrading the same policy or taking additional policies.
You need to check the insurance cover, which you have as part of group insurance scheme of your employer and deduct it while buying accident insurance cover yourself.
It is the next important form of insurance. First, you need to check about the group health insurance scheme from your employer. Most companies have group insurance for all employees that usually cover each employee (& his dependent family) for about Rs. 4 to 5 lac. If your employer has this policy, you need not worry a lot. Just cover yourself for contingent periods when you are switching jobs. If employer of your spouse covers you as part of its insurance scheme and both of you do not plan to change jobs at same time, you may avoid buying any additional health insurance.
If you are self-employed or your employer does not have a health insurance for its employees, you must buy health insurance for yourself and your family. A cover amount of about Rs. 2 lac for individual and Rs. 5 lac for family should suffice till you reach about 40 years of age. After that you should increase cover amount.
It is one of the most mis-sold financial product in India and probably worldwide. It is the most popular form of insurance to an extent that for many people insurance means ‘Life Insurance’. However, not everyone needs life insurance at every stage in life. It is a tool to help your dependents when you are no longer with them. If you have no dependents, you do not need life insurance.
You should take life insurance only when you have taken a loan, have a non-working spouse or have dependent children &/or parents. If you are a bachelor or a DINK (double income no kids), you do not need life insurance and should not buy it. Most common sales argument by any life insurance salesman is that you should buy insurance at an early age so that you get the benefits of lower premium. This is only a sales gimmick. The analysis reveals that insurance bought at younger age if you do not need it, is actually a costly option. You may read about it here: Should you buy life insurance at an early age to benefit from lower premiums? Premiums paid for the period when you do not have any dependent make early insurance purchase the costliest proposition. Therefore, young age should not be the only reason to buy life insurance.
How much insurance cover you should have?
It depends on your commitments. It should always be at least equal to your existing loans and the amount needed to replace your monthly salary (as calculated under Accident Insurance section above).
You should take only term insurance. Term insurance is a pure insurance scheme where you pay premium to insurance company and in case of your death, it pays the insurance amount to your dependent. If you survive the insurance period then you or your dependent do not get any money. This is the way pure insurance works and it should be like this.
Term insurance is very cost effective and leaves lot of money in your hands, which if you put in bank FDs (riskless investment) you would earn a lot more than insurance cum investment plan of life insurers.HDFC Life offers term insurance of Rs. 30,00,000 for a duration of 30 years for a 25 years old non-smoking male person for an annual premium of Rs. 3,990 (product: Click-2-Protect, date: July 29, 2014). Good news is that the premium of pure term life insurance have been falling in India over last decade and are expected to fall further. You may read about it here: Life Insurance Premiums are declining! Will this trend continue?
There are many good life insurers in India e.g. LIC, SBI Life, HDFC Life and ICICI Prudential. LIC is the most famous but is among the costliest. Rest three are also equally good and offer good plans at competitive prices.
Once insurance requirements are completed, you should think about investments. There are many investment options available for a common person like Debt (FDs), Equity (Stocks, Mutual funds), Real Estate, Gold etc. These options are called Asset Classes.
These include bank FDs, post office deposits, public provident fund etc. They are very safe and provide returns of about 8%-10% per year.
These include stocks, mutual funds and unit linked insurance plans (ULIP).
- Stocks: Buying stocks directly requires a fair bit of hard work from the investor. One needs to learn an approach to select stocks. You may use some parameters in my post Stock Selection Strategies, to select good stocks to invest. But if you are not comfortable with investing in stocks directly, then you should invest in stock markets via mutual funds.
- Mutual Funds: There are many websites, which help you in analyzing mutual funds like Value Research, Moneycontrol, Morningstar. You should choose any two 5-star rated equity funds (Diversified funds or Large Cap funds) and invest monthly. All mutual funds provide option of investing monthly by systematic investment plans (SIP). You should always choose direct plans of mutual funds schemes and avoid regular plans. For comparison you may read this post: You should always invest in Direct Plans of Mutual Funds. Here is the reason why?.
- ULIP: ULIPs are insurance products which invest people’s money in share markets. These are the most mis-sold products in India and you should never invest in them. Innocent people have lost more money in ULIPs than anywhere else. Main reasons for losses are very high commissions and hidden charges.
It is a very high-ticket investment, which we usually buy taking a loan. As the loan amount is substantial, any opinion on real estate as part of portfolio is appropriate only after looking at complete financial position of a person. We should always consider that it is a risky investment, which many times, becomes highest part of our total investments. Any wrong decision can put all our savings in danger.
We can invest in physical gold and keep it in locker or buy it online via mutual funds and keep it in demat account with a bank.
We should always divide our investments among these different investment options. This is called Asset Allocation. Amount of money, which should be put in each asset class differs from person to person. For each person, asset allocation changes at different life stages.
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I would write another post on asset allocation sometime later. Until then dividing your investments equally between debt, mutual funds, real estate and gold can be a good option and you may also read suggested investment books. Also give comments and let me know how you find these guidelines.