What is a financial plan and why have one?

Having a financial plan is a lot like having a travel plan — it identifies where you're going, how and when you'll get there, how much it'll cost, and things do along the way. Like planning a vacation, your financial plan can be loosely structured or highly detailed based on your individual needs. But having no plan at all could leave you stranded in the middle of nowhere.

A financial plan answers three primary questions:

  1. How much, when, and where should you save while you're spending less than you earn? Examine your wages, debt payments, living expenses and other budget items to determine how much to contribute to your plan (when you have a cash-flow surplus), and decide which account the money should go in.
  2. How should your savings be invested until they're needed? Identify which asset classes to invest in, how much to put in each, and which actual investments to use. Diversification helps you manage investment risk.
  3. How much, when, and from where will you access savings when it comes time to spend them? Address situations when financial needs exceed available cash from income (a cash-flow deficit) and must be supplemented by withdrawing savings from your plan. This might be a limited-term need such as paying for a child's college education, or a lifetime need such as partial or full retirement.

To properly address these questions, identify your financial goals. Questions to ask yourself include:

  • What kind of current lifestyle do you want or need? How much will that allow you to save?
  • What kind of future lifestyle do you want or need? How much will you need to spend?
  • When do you want or need to stop contributing and start using savings?
  • How much investment risk do you want or need to take?
  • Do you want or need to leave a specific amount of money after you're dead?
  • What else do you want or need?

It helps to think in terms of both want and need. This may allow some goals to lean toward the “want” side, while others can be closer to the “need” side. For example, you may choose to work and save for a longer period of time so you can lower your savings rate to take nicer vacations now, or you might plan on spending less in the future so that you can lower your investment risk now. Planning can help you balance comfort and compromise.

A financial plan should have a constant method of evaluating whether it's working, so that you can check it on a regular basis to monitor progress. Once you have a working plan, you can use it to make informed choices. Check to see what a sacrifice really gets you so you can decide if it's worth making. Change the plan up to see how it would look if you lost a job, became disabled or died; this may help define your insurance needs. Figure out what to do with a bonus or unexpected tax refund. There's a lot if useful information you can obtain from a measurable financial plan.

Lastly, here are a few tips and some common mistakes to avoid when maintaining your own plan. Even small errors can compound over time.

  • Be realistic with investment returns; don't plan to outperform the markets.
  • Account for market risk; don't assume the same return will occur every year.
  • Don't forget to plan for fees, taxes, and inflation.
  • Don't plan on dying too young.
  • Revisit your plan regularly to see if it's still working.
  • Ask someone else to check your work, whether it's a close friend, family member, or a professional planner.

Next time I'll discuss when and how you should hire a financial planner.

More about...Planning

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kev
kev
13 years ago

Good advice. I’m amazed by how some people will take the time to sit down and plan out the following week’s groceries, but will not put the same thought and effort into planning their finances.

plonkee
plonkee
13 years ago

“Don’t plan on dying to young”

Very funny, and so, so true on every level.

DC Economist
DC Economist
13 years ago

Groceries, that’s funny. I always have a list for the grocery store, so I avoid buying any splurge items. I’m somewhat draconian in my budget. I agree. Having a plan provides direction and guidance. When I did not have one, I spent more money than I realized. Now, after alot more education, I find myself really questioning whether I even want to spend the money I’ve budgeted for that one CD a month I have budgeted to buy. It really does help stop impulsive buying. And I tell you what, my CD collection has gotten alot better in terms of… Read more »

Liza
Liza
13 years ago

“Revisit your plan regularly to see if it’s still working.” This is one I think many people forget! Four years ago, as I was just starting to learn about investing, my partner and I sat down with a financial planner and selected mutual funds for our 401k rollovers and IRAs. A major move, a house, and a baby later (not to mention tons and tons of financial education!), we hired a planner to give us a “reality check.” Since we’ve both been good about socking away 15% in our 401ks, his view was that we were in good shape —… Read more »

SBF
SBF
13 years ago

Now, after alot more education, I find myself really questioning whether I even want to spend the money I’ve budgeted for that one CD a month I have budgeted to buy.

I’ve had the same experience. Once I sat down and really thought about what I wanted my financial present and future to look like, the choices became clear. I no longer have the impulse to make random purchases because instead of feeling like I’m acquiring something, I feel like I’m losing out on future comfort and security!

What a change!

Eric
Eric
13 years ago

Do you have any suggestions of what type of format or layout to use, or what a financial plan would look like? Is it just a list of goals or should it have calculations to go along with it – I’m thinking the latter would be more useful. I’m just trying to figure out how to put it down on paper, or excel, or whatever. Is there a form somewhere I could download and fill in or anything useful like that?

DC Economist
DC Economist
13 years ago

Eric,

I believe we will have something for that this week. I am working on it as we speak, have been for awhile.

RGalgon
RGalgon
13 years ago

A great book for an introduction to all of this is the “The Bogleheads’ Guide to Investing”. I just finished reading it and was really impressed by its even-handed approach and sensible introduction to a wide range of topics for planning for, and investing in, your future.

Brian
Brian
13 years ago

Great comments here, but keep in mind that a financial plan is about much more than investing. A CFP like Dylan will address all of your financial needs. Investing is a big part of it, of course, but insurance, debt and cash flow management, estate planning… it all has to be integrated to have a truly comprehensive plan.

Nice primer, Dylan.

Brian Bell, ChFC, CFP

Dylan
Dylan
13 years ago

@ Eric, there are a number of ways to lay out your plan on paper or using Excel. One way is by using a timeline format that includes all cash flows into and out of your plan at the time they are expected to occur. You can also identify goals on the timeline along with the cash flows. If you want to get fancy, you can back test your cash flow timeline in Excel by applying historical investment returns to the money invested in the plan to see how your plan would have performed across various periods in history. Don’t… Read more »

MoneyChangesThings
MoneyChangesThings
13 years ago

While it’s important not to die too young, you can also OUTLIVE your financial plan. Young people coming of age today can easily expect to live into their 90’s, so if you retire in your 60’s, you could be looking at financing a 30 year retirement!
This has already happened to my 90 year old aunt. Her greatest fear now is outliving her resources.

Suparna Tyers
Suparna Tyers
13 years ago

Hi,
I live in Melbourne Australia. Our accountant has just drafter a financial plan for our superannunation, insurance, etc which looks like something that has been punched out of a computer program. He told us that there would be an ongoing fee which would be worked out on a percentage basis every year. This seems like a lot of ongoing costs. What do you think?

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