I often hear the terms financial planning and investments used interchangeably. A common misconception persists that the two terms are the same. In reality, they are two very different things.
Financial planning is the process of creating a road map for the journey through life, which encompasses goals, aspirations and future plans.
An investment strategy, or picking investments, is akin to selecting the correct vehicle to travel on your journey and should take into account variables such as tolerance to investment risk, expected timeframe to achieve goals and prevailing market conditions.
A financial plan is just that, a plan that is created to ensure the correct financial decisions are made, both today and into the future. At its core, this plan defines important milestones that you wish to achieve, such as what age you would like to retire, sending children to an Ivy League university, or the date you intend to move back to your home country.
The ability to earn and save money is assessed, along with the capacity to pay down debts, such as mortgages, credit cards and other loan payments. Budgeting income and expenditure is important, however having a monthly budget alone is not a financial plan.
Tax consequences
As part of the planning process, tax consequences should also be considered relating to both the current country you reside in, or where you may wish to reside. Tax obligations vary from country to country and there is no guarantee that tax planning in one country will be compatible with another. Preparing for an eventual relocation or retirement in a highly taxed jurisdiction may require pre-planning years in advance, which can help to avoid surprise tax bills.
Once you have a comprehensive understanding of your future goals, along with amounts available to earn and save along with anticipated timeframes, you have the basics ready to create a structured financial plan.
A great example of planning is to consider an individual aged 40 wanting to retire at 60 in the UK, who currently has savings of $500,000 and would like to have a retirement income of $50,000 per year.
We know the individual has 20 years in order to reach the stated goal. By calculating after inflation what $50,000 per year would be, we can work out the difference between the current investable amount today and the target amount required in 20 years.
As the UK is the preferred retirement destination, we also know that the recommended plan has to be efficient from a UK tax perspective.
Good financial advisers should be implementing cashflow modelling software to build financial plans for customers. This is an excellent visual way to forecast a financial future, which clearly outlines a current position and then aims to extrapolate the data provided forward into the future. While average life expectancy is taken into account, forecasts should extend beyond this to ensure the plan remains suitable should you live longer than expected.
Investment planning
Without sound financial planning, investing can become aimless. The goal of investing is to generate a return, however, why the return is required should be carefully considered in advance. If there is no plan for the investment, it is difficult to know when the investment should end. This can lead to withdrawing funds during a market downturn or being exposed to an inappropriate level of risk and volatility. The ability to achieve financial freedom depends on having a well-defined financial plan.
Only when a financial plan has been created is the investment vehicle considered. The plan helps to determine the investment return required, the level of risk an individual is willing to accept, current and future levels of inflation, and if any ethical or religious sensitivities are applicable.
Clearly defining the objectives and requirements of any investment gives confidence to the individual and helps achieve a sound strategy that is sustainable over time.
Over time, goals may change, due to family commitments, changes in employment, or health-related issues. Good financial plans will be created with flexibility built in, meaning if a change in strategy is required, things can be easily altered to suit.
With this in mind, it is important to review plans regularly, which ensures they always stay on track. There also needs to be consideration for preserving a legacy – which is what happens to your estate in the event of death. Planning with the use of wills and trusts gives peace of mind that beneficiaries and loved ones are protected into the future.
Picking investments is an important part of financial planning, but not the only consideration. Prudent financial planning is an all-encompassing process that takes many different facets of life into account, along with financial information and future goals and aspirations.
Chris Keeling is founder and senior executive officer at Metis, a DIFC-based wealth adviser
