How should I start planning my finances?

How does one begin financial planning? Though a lot of advice on investing and planning is available in the media and on the Internet, where does one actually start? What should be the first step? The question is basic, but like all fundamental ones, it's an interesting query to answer. While planning your finances, the first step should be the assessment of various risks to your income.

Financial planning, at its core, is about managing one's income across a period of time. Sometimes, we set aside today's income for tomorrow; at other times, we spend tomorrow's income today. Even if we use it to build an asset, we hope to use it in the future, if there is a need. So, the obvious first step is to ask how secure your income is and the risks it can be exposed to. During the early stages of life, the focus is on securing income, which is why career plans emphasise on earning one. When we encourage a student working at a call centre to consider higher education, we are persuading him to invest in the human asset to enhance future earnings. When my driver chooses to educate his son in an English-medium school, he is keen to secure his son's future income.

Every investor should determine the potential risks to his income and begin the financial planning process accordingly. For a film star or a sports star, a short period of high income is a risk. Building assets that replace his professional income when he retires early should be his primary strategy. Building a second career could be another one.

A salaried investor would identify retirement as a source of risk and set aside his current income to build a corpus that would replace regular income after he stops working. For an entrepreneur, whose life's earnings are invested in his business, the risks are tied too closely to those of the business venture. The assets he builds outside his business will have to consider this threat. Even a corporate treasurer aims to build other income that will de-risk the main source of income for the business.

The two key elements of managing risk are insurance and investment. To insure is to secure the income from unexpected events, such as poor health and death. To invest is to augment, or in the best case, replace the regular source of income with that from investments.

The third element is more tactical and involves using leverage or borrowings. It involves building assets using borrowed funds, so that the benefit of the asset over and above the borrowing cost, goes towards augmenting the income. The risk in this strategy is the possible fluctuation in the value of the asset and the possibility that it drops below the outstanding loan. Day trading with margin funds is a high-risk, income-generating tactic, if the cost of funds exceeds the income generated.

Risks to income can also come routinely if it is ill-matched to your needs or simply inadequate. Illness in the family can push an uninsured, low-income family into indebtedness. Family functions, expenses on durables, renovation, educational expenses are all lump-sum requirements for money that cannot be met by regular income. Financial planning is about providing for such large outlays, either through savings and investments, or through borrowings and staggered repayment. How a household manages the routine and expected charges on income, and the ad hoc and unexpected demands on it, determines how financially healthy it is. Routine borrowings reduce the future income and ability to spend and save, while regular savings cushion possible shocks to the future income. As risks to future income drop, households tend to spend more and save less. Ability and willingness to borrow also moves up with increased confidence about the future income.

Hence, financial planning cannot be described narrowly as a disciplined and frugal exercise of setting money aside for your needs. As long as it is aligned well to the expected future income and realistically considers the risks, it is a step in the right direction.