We all know the importance of living within our financial means. In order to live a financially balanced life, you need to control and monitor both your short term financial needs as well as long term financial needs.
The short term financial needs involve carefully planning and budgeting your expenses. In a financial speak, every individual or a family has two types of expenses: non discretionary and discretionary. Non discretionary expenses are those expenses that you must incur in order to avoid a serious penalty. Examples of such expenses are payment on a loan, credit card debt, mortgage, etc. Discretionary expenses are those that could either be reduced or completely eliminated. For example, travel, dining out, and other entertainments related expenses are discretionary.
Certain expenses e.g. food, clothing, and shelter are while non discretionary, they also carry a discretionary component e.g. what kind of food, what kind of clothing, and what kind of shelter.
You may not have much of a control on your income but you certainly have a good control on your expenses. Your savings rate is simply your income minus all your expenses. Note that contribution to an emergency fund, or a retirement savings account, or a college education fund are the examples of savings (not expenses). These savings help you accomplish your future financial goals or future expenses. Assess your savings discipline in the "Cash Management" section of PFI.
From a financial management perspective, your most important goal is to maximize your savings. This is a very important discipline that most people tend to defer. Maximizing savings involves effort and willingness. First it requires you to decide whether an item or service that you are buying or are about to buy is essential. The second thing is to figure out the best price of that product or service by shopping around. The third thing may be to look for an alternative. For example, someone needs to buy a car for commuting to work. While there are different choices of cars, starting from old to new, one brand versus the other, buying versus leasing, there may also be a substitute e.g. using public transportation or a bicycle. The "Cash Management" section of Personal Financial Index® (PFITM) tool will allow you to interactively review your expenses against the income. The pie charts provide a high level and one level deeper view of your expenses. This helps you visualize where your dollars are going.
Once you have taken a good control of savings, the second part is to figure out where those savings should go. From a financial planning perspective, you need to have an emergency fund with at least six months worth of expenses. You should also develop a plan for your future financial goals e.g. retirement, a major purchase down the road e.g. a home downpayment, and kids' college education. The PFI tool allows you to review all these financial goals and determine whether you are on target to accomplish those goals or not. A good financial management requires that you review the status of these financial goals often.
Once you have established a good savings discipline, the next thing for a good financial management is to make it earn. Don't let it sit idle in a checking account. Keep in mind that the inflation reduces the purchasing power of your dollar. Therefore, it is important to invest your savings prudently. You want your money to compound at a good rate of return. Checkout the magic of compounding by changing the rate of return on any of the savings sections in PFI: Retirement, College Education, and Major Purchases. However, you need to invest your savings based on how far out you need the money from your savings, to what extent you are willing to lose your money for a potential gain (risk/reward). For example, if you need the money back in a couple of years, you need to invest your money such that the principal is protected. If the time horizon is longer, you are more likely to come out ahead even if the value of your investment goes down in value in the short term. But before you decide to invest in risky securities, make sure you evaluate your risk capacity. Lastly, stay diversified. Do not put all your eggs in one basket.
Depending on the complexity of your finances and your investable assets, you may want to seek the help of a qualified financial planner or financial advisor. These professionals make their living by working with their clients one-on-one, understanding their financial needs, and creating suitable investment plans. A good financial advisor would help you save much more or help you earn much more than his/her fees. At the end of PFI exercise, you will be able to see reputed financial advisors near you. However, before you decide to work with a financial advisor, make sure you do a background check and have a face to face interview. Read how to find a financial advisor to learn more on this topic.
