If there’s one financial hack I’d give my younger self, and one that I hope will stick with me throughout my financial freedom journey, it’s the importance of having crystal clarity on which game I’m playing.
I learnt this lesson from one of my favourite personal finance books: The Psychology of Money by Morgan Housel (The book is also available on Amazon)
He writes:
“Being swayed by people playing a different game can also throw off how you think you’re supposed to spend your money.
So much consumer spending, particularly in developed countries, is socially driven: subtly influenced by people you admire, and done because you subtly want people to admire you.
But while we can see how much money other people spend on cars, homes, clothes, and vacations, we don’t get to see their goals, worries, and aspirations.
A young lawyer aiming to be a partner at a prestigious law firm might need to maintain an appearance that I, a writer who can work in sweatpants, have no need for. But when his purchases set my own expectations, I’m wandering down a path of potential disappointment because I’m spending the money without the career boost he’s getting.
We might not even have different styles. We’re just playing a different game. It took me years to figure this out.
A takeaway here is that few things matter more with money than understanding your own time horizon and not being persuaded by the actions and behaviors of people playing different games than you are.”
This hack isn’t just applicable to decisions regarding clothes, cars, vacays and homes. You should also use it while deciding what to invest in: you don’t just wake up one day and buy X asset, stock or bond, perhaps because your friend convinced you, everyone is investing in it or for fear of missing out because people are making money.
You should make investment decisions based on your goals. This article will help you come up with a personalized financial plan to help you achieve your financial goals.
What is Financial Planning?
At a very basic level, financial planning simply means gaining an understanding of your financial position.
Your financial position is your net worth at a specific point in time.
How to calculate your net worth
Your assets-your liabilities = your net worth.
What is an asset? A resource that you own. Something useful or financially valuable for example land, a bond, shares in a company etc
Liability is what you owe. Such as debt, school fees arrears, rent arrears, credit card balances etc
Simply, your net worth is what you own minus what you owe.
Financial planning can be done on your own or with the help of a professional.
Before we dive in on how to financial planning is done, let’s start with understanding your Financial Life Cycle.
The Financial Life Cycle
The financial life cycle is a series of stages individuals pass through in their life’s journey. The stage you’re in will dictate your priorities and goals. These priorities change as your progress through the different stages.
Can you think of something that was a financial priority in your early 20s but you currently don’t spend money on?
As you move through each stage of the financial life cycle, your financial goals will evolve due to shifts in lifestyle or circ*mstances such as career change, marriage, relocation, raising a family, home purchase, inheritance, ageing parents etc.
The Three Stages of the Financial Life Cycle
There are three stages to an individual’s financial life cycle, each of which is characterized by different life events.
Stage 1: Capital / Wealth Accumulation (25 – 55 Years)
In this stage, you earn your wealth, usually by trading your time for money. Your employer demands that you work for X amount of hours per day and you’re paid an hourly rate.
Even if your contract states that you’re paid per month, you’re still paid per hour. You should take time to calculate your hourly take-home pay.
How to calculate your hourly take-home pay
Hourly-take-home-pay refers to how much money you get after taxes and deductions for every hour you work.
Here is how to calculate it in 2 simple steps:
- Add up your total monthly take-home pay (your gross income minus taxes and other deductions.)
- Divide it by the number of hours you worked that month.
You should take this further and include your commute time in your calculation for your hours worked.
If you work 40 hours per week and you have a 1-hour commute to and from work, the truth is, you work 50 hours per week.
If you get paid $4,500 per month and work 180 hours, your hourly take-home pay would be $25 per hour.
This figure is important as it’ll show you the reality of the value of your time, and you’ll also be in a position to brainstorm some ideas on how to increase your take-home pay such as reducing your commute or starting a side hustle with scalable income.
In the wealth accumulation stage:
- Your investment objective is to accumulate wealth.
- Your tolerance for risk is high.
- Your time horizon is long.
- Your resources are limited.
If you’re in this stage, you have to save regularly and consistently and you have to invest your savings in riskier assets with a potential for growth to increase your income and net worth.
Your savings will represent a bigger portion of your wealth in the early stages of wealth accumulation but will gradually decline, as a percentage of your overall wealth, as compounding growth takes effect and investment returns dominate.
The key to success in this stage then is to learn how to manage your cash flow through proper budgeting.
Grab The Wealth Tribe’s Budget Tracker here.
Stage 2: Wealth Preservation (55 – 60 Years)
In the wealth preservation stage, you’re approaching retirement so your focus shifts from growing to safeguarding your wealth to attain the financial security you’ve worked hard to attain.
In the wealth preservation stage:
- Your investment objective is to preserve your wealth.
- Your tolerance for risk is low to moderate.
- Your time horizon is medium to long.
- You have accumulated significant resources.
- Your income is higher and perhaps rising.
The two major factors that matter in retirement planning are human capital and financial capital.
Human capital is the present value of your total expected future income while financial capital is the combined tangible and intangible assets you own such as stocks.
The goal of retirement planning is to use your human capital to build financial capital to provide a secure retirement income. You accumulate wealth through the earning years, preserve it towards retirement, and then draw it down in retirement.
If you don’t properly manage your wealth, you will have nothing to work with in retirement when your human capital nears zero.
Stage 3: Wealth Drawdown
This is the stage where you live off your wealth and/or distribute it to others. Your focus turns to income generation to fund retirement.
The last stage is where the focus turns to generating a steady stream of income to fund retirement.
Life expectancy has been rising due to advances in technology. You’ve got to have a strategy that guarantees a steady stream of retirement income you cannot outlive. Outliving your retirement money is a reality for more than 80% of Kenyans, you shouldn’t be part of this statistic.
Financial goals should be updated to reflect the lifestyle and/or circ*mstantial changes as you through the three stages of the financial life cycle.
How to Create a Personal Financial Plan
Here are the 4 steps in the financial planning process:
Step 1: Determine your current financial status
Step 2: Set your financial goals
Step 3: Explore investment choices
Step 4: Establish rules to manage your cash flows
Step 1: Determine your current financial status
The first step in the financial planning process involves understanding your cash flows. There are different aspects to this process:
A. Income (Cash Inflows)
A critical aspect of proper financial planning is understanding your cash flows (income and expenses) and how the two are connected to your assets and liabilities.
Your income is the sum of all wages, salaries, profits, interest payments, rents, and other forms of earnings received over a period of time.
Income sources can be categorised as follows:
- Salary
- Business Income
- Dividend Income
- Capital Gains
- Interest Income
- Rental Income
- Miscellaneous Income
Start by listing all your sources of income and the exact amounts, where possible. And you can find a video on how you can increase your income sources here.
As shown in the screenshot below, The Wealth Tribe Budget Tracker helps you to track all your incomes.
The difference between your total income and taxes is your disposable income.
B. Expenses — Cash Outflows
Expenses are all costs you incur directly or indirectly, other than those for business or investment purposes. These include rent, utility bills, food, transport, insurance, legal fees, etc.
Tracking your expenses reveals your priorities as it helps you answer the age-old dilemma ‘where did my money go?’
The way to determine your monthly expenses is to look at your Mpesa statement, bank statement and any receipts in your possession for the past month. Simply add all.
This activity will give you an idea of how much you spend every day, week or month, and perhaps inspire you to review your priorities.
As shown in the screenshot below, our customizable budget tracker will allow you to track your expenses every month which will help you to come up with mini-goals for each new month and set better financial goals for each quarter/year.
There are two basic types of expenses:
Fixed expenses
Fixed expenses stay the same period-to-period and typically include expenses such as rent, insurance, subscriptions, utilities (water & electricity) and transportation.
These expenses must be paid.
Although fixed expenses do not fluctuate from period to period, you can replace them with lower fixed expenses. For example, you can move to a cheaper apartment.
Variable expenses
Variable expenses change period-to-period and may include food, entertainment, fuel, or airtime.
C. Net Cash Flow
Net Cash Flow is the difference between your cash inflows (income) and outflows (expenses).
A positive level of cash flow — the result of spending less than you earn — is important because it shows your ability to generate cash that you can use to:
- Acquire Assets
- Pay Off Liabilities
- Build an Emergency Fund
Bills don’t disappear when cash is not coming in or is delayed for some reason. Maintaining a positive level of cash flow is important for surviving the difficult times and a key ingredient of financial health.
The difference between your cash inflows (income) and outflows (expenses) divided by disposable income, stated in percentage terms, is your savings rate.
As shown below, The Wealth Tribe’s Budget Tracker helps you to calculate your savings rate.
“And since you can build wealth without a high income, but have no chance of building wealth without a high savings rate, it’s clear which one matters more.” Morgan Housel, The Psychology of Money
Tracking your income and expenses will help you understand your cash flow situation and how it relates to your financial position (assets, liabilities and net worth).
D. Assets
As explained above, the difference between your income and expenses is your Net cash flow.
This amount allows you to acquire assets.
An asset is a resource: something useful or valuable. An asset class is a group of assets with similar characteristics.
The main types of asset classes are:
- Equity Securities (shares)
- Fixed Income Securities (bonds)
- Cash and Cash Equivalents or Money Market Instruments. These include Treasury Bills, Commercial Paper, Certificate of Deposit, Savings Accounts, Cash.
- Real Estate
- Commodities
- Futures and other Financial Derivatives
The first three assets are known as Traditional Investments, and the other three as Alternative Investments.
- Liabilities
A liability is a debt or an obligation that represents a claim on your assets as a result of past transactions or other past events.
Liabilities may include:
- Debts
- Rent Arrears
- School Fees Arrears
- Car Loans
- Mortgages
- Credit Card Balances
You have to actively manage your debt because an increase in liabilities without a corresponding increase in assets erodes wealth (net-worth).
F. Calculating Your Net Worth
When you have a clear understanding of your income, expenses, net cash flow, what you own (assets) and what you owe (liabilities), then you can comfortably calculate your net worth.
Your assets – your liabilities = your net worth. By understanding the above, you’ll have established your current financial status which is the first step in the financial planning process.
Step 2: Set Your Financial Goals
Financial goals are the income, spending, savings or investment targets you aim for in the management of your money at every stage of your financial life cycle.
We started by establishing your current financial status because that information would help you set realistic financial goals.
You cannot, for example, set targets on your expenses if you don’t know the percentage of your income that goes towards expenses.
Similarly, you cannot set savings targets if you don’t know your savings rate.
How to Set Financial Goals
I already wrote an in-depth guide on how to set financial goals that yield results. Apart from dividing your goals into short term, intermediate and long-term goals, it’s also important to think about:
Specifically, how far away is the goal?
This is the amount of time between now and when the goal must be funded.
What’s the spending duration?
This is the length of time you expect to fund the goal.
Priority
This is the numerical ranking of how important each goal is.
Estimated cost
The amount you expect you’ll need for the goal.
Step 3: Exploring choices
Once you had a clear understanding of your financial position, and how your cash flows are connected to your financial position, you proceeded to list your financial goals.
You looked at your current financial situation and based on the insights gained proceeded to set financial goals.
Your financial goals will then inform your investment objectives; the fundamental reasons why you invest.
Remember that at the beginning of this article we established that you don’t just wake up one day and buy X asset, stock or bond, perhaps because your friend convinced you, everyone is investing in it or for fear of missing out because people are making money?
Yup! Once you have your financial goals, you then proceed to explore investment options available for you. Then you match each goal with a suitable investment opportunity.
There are three main investment objectives:
- Capital Preservation
- Income
- Capital/Wealth Growth
Say one of your financial goals is to generate enough passive income to cover your rent.
The fundamental reason why you will be investing is to generate income.
Therefore, your investment objective will be Income.
Your Investment Strategy (the approach you adopt in selecting individual investment opportunities to achieve a target) will be the Income Strategy. This is a strategy that seeks to identify assets that generate above-average income, rather than long term growth.
In this case, which investment option would you choose for your goal?
You would pick fixed income securities such as bonds.
Why not pick shares for this goal? I’ll give a FREE 30 minutes coaching session to a random person who answers this correctly! Leave your answer in the comment section.
Your investment strategy and tactics should be tied to your financial position, financial goals and investment objectives.
One of the roles I play as a financial coach is to help you come up with an investment strategy that matches your financial goals. Let’s work together to create magic!
Step 4: Establishing rules to manage your cash flows
You need a system to manage the inflow and outflow of money. This system tells your money where to go; otherwise, you wonder where it went.
For example, some Christians tithe 10% of their disposable income. In the same way, you should establish where your money will go when you receive it. Where do you direct your coupon payments from your bond investments?
You should allocate a percentage of your income to each of your investment goals.
As established earlier, your financial goals should be updated to reflect the lifestyle and/or circ*mstantial changes as you move through the three stages of the financial life cycle.
Was this article helpful? Can you comfortably create your personal financial plan? Do you need help? Leave your feedback in the comment section, I respond to all comments and questions.
