Welcome to Part 2 of Personal Finance Planning Process, where if you have totally NO CLUE on how to plan out your finances, this may offer some answers for you! And again, I am no professional in this matter, so if you wish to seek professional advice, you may want to look for a professional financial planner to help you with that.
If you haven’t check out Part 1 of Personal Finance Planning Process, click here.
Without further ado, let’s get started!
Previously I talked about how personal finance planning is a 5-step process.
- Know your Client (KYC) – i.e. yourself
- Insurance – hedging human capital
- Goals & Needs
- Risk Profile
- Investment Strategy
In Part 1, I have covered 1. Know your Client (KYC) – i.e. yourself and 2. Insurance – hedging human capital. Today I will be covering 3. Goals & Needs and 4. Risk Profile.
Goals & Needs
Previously, we used a totally fictitious character, Mr Rich, as our case study. Today, we are going to continue his story.
Everyone has their own wants and needs, so does Mr Rich. Mr Rich wishes to buy his own house; Mr Rich wishes to buy his own car; Mr Rich wishes to get married; Mr Rich wishes to retire by the age of 60; Mr Rich wishes to travel the world once a year when he retires. These are not just Mr Rich’s wants – these are most of our wants as well.
However, how can an accountant earning just $4,000 get to do all that? Well he can, with proper financial planning of course!
Let’s list down all of Mr Rich’s wants in a chronological order in this timeline below
Downpayment of a typical 4-Room BTO flat
Based on HDB’s website, the average selling price of a 4-room flat in a non-mature estate with grants will cost around $200,000.
Mr Rich can opt for a HDB loan that means he would have to make a 10% downpayment of $20,000 for his new flat. Luckily, Mr Rich has been working for 2 years and has some money in his CPF-Ordinary Account to make the downpayment. Subsequent loan payments can be made using CPF as well. Hence he will opt for the following at the age of 30:
Average cost of marriage
Mr Rich plans to get married by the age of 30. He will be setting aside $30,000 for the the entire wedding from the photoshoot to the wedding banquet that his traditional parents would love if he has it. This is the extra amount that he has to fork out after collecting all the ang baos that his generous guests will give on his big day.
2nd-handed car downpayment
For his first car at the age of 32, Mr Rich would like to get a second-hand car with a remaining COE period of 2 years. This will cost roughly $25,000. The upfront payment he would have to make will be 30% downpayment + insurance + first instalment + transfer fee = $9,500
Retirement expenses per month
Mr Rich is a frugal man and thinks that he will require $3,000 per month after he retires to sustain his lifestyle. $3,000 is enough for him to live comfortably and to go down to his favourite restaurant every now and then and for him to enjoy his daily coffee at the kopitiam near his place – provided that it will still be around by then.
Travel Expenses per year
Travelling the world is on his bucket list. Mr Rich aims to visit a different country every year after his retirement with his beloved wife. This is his definition of “living the retirement life”. He thinks that he will miss home terribly if he leaves Singapore for too long. Hence, he will only take these trips only once a year, with each adventure lasting for not more than two weeks. He is prepared to spend $4,000 to fulfil this wish every year.
Funeral Expenses at end of life
Death is inevitable. However, Mr Rich wishes to be self-sufficient and not rely on his family for his funeral expenses because he believes that the best financial gift that he can give them is to be financial independent himself. Hence, he has set aside $20,000 for his entire funeral expenses
If we do some calculations and projections, we can actually find out roughly how much returns should Mr Rich’s investment portfolio get every year:
Some assumptions that are made:
- Inflation = 2% per year
- Annual savings will be reduced to $12,000 due to car mortgages and increased insurance expenses.
- Annual income and expenses are constant
PV of Retirement & Travel Expenses & Retirement Expenses at age 60 = $667,516.76
That means Mr Rich would need a total of $667,516.76 by the time he turns 60 years old.
That means he will need 3.76% per year annualised in order to achieve his goals!
Now wait a minute, you mean he only needs 3.76% per year to achieve all his goals that he has set out AND pay for a flat AND get married AND plan for his retirement? Well, even though there are a lot of assumptions made, the answer is still yes! This is the power of starting to invest early and the magical concept called the time value of money!
Next, we need to understand what kind of investor Mr Rich is. There are 3 types of risk profiles:
Aggressive: An aggressive investor is prepared to accept higher risks in order to obtain greater investment returns with a potential to lose all or more of his capital
Balanced: A balance investor seeks a mixture of capital growth and regular income from his investments; prepared to accept moderate amounts of risks to earn more potential returns
Conservative: A conservative investor seek capital preservation and a safe regular income is a priority over capital growth.
There are also a few factors affecting each individual’s risk profile: Investment time frame, risk capital, investment experience.
Investment Time Frame
For a longer investment time frame, the risk tolerance should be higher as there is more room for aggressive investing. When the investment time frame is relatively short, the investor should be more conservative. That is why we are able to take on more risks when we are younger.
This is the money that is available for investment, which should be the money that “you will not touch” and in excess of your normal spending and liabilities also known as net worth. The higher net worth you have, the more you are able to take risks. Also if the capital that you are risking is a small percentage of your overall net worth, you can also take more risks.
Typically, seasoned investors are able to take more risks as they have been investing for quite some time. New investors should aim to preserve their capital and learn more before committing more.
Fortunately, there is a quantitative way to determine your risk profile. Below are two risk profile questionnaires from DBS Vickers (from page 11) & UOB Kay Lian (from page 5) to help their clients understand their risk profiles better. It is a set of 11 questions. Complete it and tabulate the score accordingly.
Mr Rich completed both questionnaires and found out that he is a BALANCED INVESTOR. This means he seeks to have a mixture of capital growth and regular income from his investors. He is prepared to accept moderate amounts of risk to earn potential returns. He accepts that there is a real potential to lose at least part of his capital in seeking moderate returns. He understands that there will be, even in times of stability, occasional periods of volatility and risk of loss of capital.
Finally, in the next part of the series, I will be talking more about the Investment Strategy that Mr Rich should take to achieve his required returns in Part 3 of Personal Finance Planning Process.