Hi there! I received a lot of requests for additional information on financial planning for 2021. People want to know the steps to take toward achieving financial freedom. While I cannot tell you what would work for you individually, I can provide a general guideline to get you started. As with any advice, conduct your due diligence and customise it to your circumstances. This guideline borrows from the principles of financial health.
What is financial health?
Essentially, financial health means that you can take control of your financial decisions. With planning, prioritising and utilising financial tools, you can meet daily expenses and save or invest in a future and create resilience to manage economic shocks. In the emerging countries context, you are financially healthy if you,
- Balance income and expenses
- Build and maintain reserves
- Manage existing debt and have access to potential resources
- Plan and prioritise
- Manage and recover from financial shocks
- Use an effective range of financial tools
Step 1: Define your objectives
As with any other plan, articulate what you want to achieve. Where do you see yourself financially in 1 year, five years, ten years, or 20 years? This is your overarching objective. For instance, your goal could be: Achieve financial independence in 10 years.
Step 2: Understand your now
In relation to your objective, determine where you are now. To successfully complete this step, you need to know every cent that comes in and what you do with it. If you haven’t already, analyse your bank and mobile money statements to track your spending habits over the last three to four months. If you only use cash, keep a record of your spending for the next month and use that for your analysis. For each transaction, determine whether it is income, debt, expenditure, donation, saving, or investment. At the end of this exercise, you should have the following information,
- Income: how much you earn, including salary, business profits, interest income, dividends, other passive income, transfer from savings, and gifts.
- Expenses: how much you spend in different categories: Housing, Utilities, Education, Childcare, Food and groceries, Personal care, Healthcare and Entertainment
- Debt: how much you owe whether they are formal or informal loans
- Savings and Investments: how much you currently pay yourself and invest in your future and how much more you need to achieve your financial goals. Yes, savings and investments are paying yourself. Leisure and entertainment as a reward is just an expense.
Step 3: What are your key results?
Now that you know where you are, you need to define the measures of success. They can be short-term, mid-term or long-term and define what financial independence means for you. Short-term (S) goals are within easy reach and are achievable within a year or less. Mid-term (M) goals are slightly longer and are achievable between 2 -5 years. Anything that takes over five years to achieve is a long-term (L) goal.
Your key result could be: Create an emergency fund covering six months of expenses totalling KES 180,000 (S).
Step 4: Create a budget
With your goals in mind, it is now time to allocate resources. You can do this using a budget. A budget allows you to record all your incomes and then distribute them to expenses, savings and investments. A budget is zero-sum, meaning assigning each cent to a particular activity. Start by listing all your revenues and spend from step 2. Does it balance out? If it does, move to step 5.
If you have a surplus, assign more to your savings and investments. Despite the urge to spend more, it will serve you better to save or invest more. If you’re falling short, you need to reduce your expenses or find additional income sources. Most people ask for raises, seek promotions, start or expand their businesses, or take on extra jobs to increase their income. However, it is easier to reduce how much you spend.
Remember, at the very least you should be putting aside 20% of your income on savings and investments and spending 50% on needs, and 30% on wants. Once you have a budget, execute on the line items, saving as much as you can on expenses whilst putting any surplus into savings/investments.
Step 5: Get out of debt
Getting out of debt is necessary if you are to achieve financial independence. For this article, let’s assume you already have several loans and you need to pay them off. There are two ways to go about paying them off. The first is the debt avalanche method, where you make the minimum payment on all the loans then use any additional funds to pay more on the loan with the highest interest rate. As you pay off the loans, you use the surplus on the next highest and so on. With this method, you pay the least interest rate possible.
The other option is the snowball method. In this method, the focus is to reduce the number of loans you have, giving you some quick wins that will motivate you to pay off the rest of your loans. In this method, you pay the minimum on all the loans but then use any surplus to pay off the one with the least balance so you can check it off.
Step 6: Invest in assets and your retirement
Use different financial products to invest your surplus. There are several options available depending on what you want to achieve and whether your goal is short-term or long-term. The idea here is to have your money working for you (growing your capital) while keeping it safe. You can use investment vehicles like T-bills, mutual funds, bonds and the stock market for the short-term.
For the long-term, consider investing in tangible assets like property. You can invest directly by buying a piece of land or buildings or indirectly through REITs. Again, it is not enough to purchase the property, it needs to be working for you. For instance, you can build houses on your property to generate rental income. Alternatively, you can move into your own house and reroute your rent payments to savings and investments.
You can also opt to create a passive income stream by investing in other people’s businesses. This can be formally through the stock exchange or informally through investing in the businesses of friends and family. You get better returns from the informal investments even though the stock market is regulated and less risky. If you choose to invest in these businesses, you need to be thorough in your due diligence. Understand the business model, the strategy and the governance before you invest. This will enable you to decide whether to make an equity investment or debt investment. Finally, have a clear agreement that stipulates expectations, returns, and rights and responsibilities so you don’t lose your money.
You should also start investing in your retirement. We often make the mistake of investing only in retirement homes without thinking about the money we need to sustain us after we retire. This means we have to find other revenue streams to feed us and pay our medical bills. For some, this means working part-time, running a business after retirement, depending on your children or even selling off assets so that you can pay your bills.
Instead, you can set up revenue streams that allow you to live comfortably when you retire. Your revenue stream could be business profits or investments that earn you dividends, interest income, or rental income. If you’re in a position to do so, take part in a pension scheme and build up your retirement fund. Some employers will match your contributions, helping you save more, and you always have the added benefit of reduced tax liability. Remember, you’re not too young to start a retirement plan. The earlier you start, the less you have to save when you have more responsibilities.
Step 7: Insurance Products
Secure your financial standing by investing in insurance products. Remember financial health is about using appropriate financial solutions for different situations. Instead of amassing savings to bail you out of your next emergency, explore insurance products as a contingency. Some insurance products you should be looking at are endowment plans, education plans, general insurance, medical insurance, and home insurance. Some of these reduce your tax liability, which allows you to stretch that shilling.
Step 8: Monitor and Measure
This step is about tracking your performance and probably one of my favourites. If you haven’t figured it out yet, I am all about measuring success and learning from failures. It is how I keep it moving. Now that you are executing on your plan, how are you doing against the set goals? Track your income and expenditure daily and then measure against the budget that you set. If you’re on track, keep up the good work! If not, reduce your spending if you have a shortage or increase your savings or investments if you have a surplus. Sticking to the plan and limiting your spending to the budget lines, ensures you achieve your target at the end of the year.
Let’s get started!