We spend a good deal of time talking about how important it is to have a Financial plan. But what does that look like? Specifically, what questions does a financial plan answer?
A good financial plan is designed to put you at ease. It tells you how likely it is that you’ll achieve your financial goals based on your current situation and planned future financial behavior.
Of course in order to do this the plan makes assumptions about the economy, stock market, interest rates and inflation. That means your plan is more of a projection than a plan. You may have to tweak your actions over time as conditions change.
But even so, there is real power in creating this document. Once you do you’ll know what actions you need to take now in order to have the best possible outcome in the future. That’s inspiring.
Let’s look at the specifics of what your plan should include to better understand this.
Your Cash Flow is the single most important component of your plan. If you bring in more than you spend, you have a positive cash flow and it allows you to add to your savings and investments. If you have a negative cash flow it means you are spending more than is coming in. That means you are spending down your assets and/or accumulating debt.
That isn’t always a bad thing, but it’s definitely a red flag. If your negative cash flow is serious enough it can damage your retirement plan beyond all repair. That means you have to do something about it, Pilgrim. But by running your plan, you’ll know what you have to do and you’ll understand this now rather than when you are broke and can’t do anything to remedy the situation.
The cool thing about cash flow is that it’s usually very easy to improve. Cut a little spending here. Cut your debt costs or earn a little extra there. Before you know it, you’ll be headed towards Happy Land.
The critical point is that your financial plan projects out what your future might look like based on your current cash flow. It takes a fuzzy concept (spending) and turns it into something very tangible. It empowers you to take small incremental steps now in order to have a far better future ahead.
Net worth shows you how much you are worth by adding up all your assets and subtracting out all your liabilities. Your net worth changes over time based on your cash flow (whether or not you add to or subtract from your investments) and how you invest.
Your financial plan will project how your net worth is going to change over the next 20, 30, or 40 years. Again, it does this based on your current situation; your planned future financial behavior and assumptions about the economy.
Some people have plans that call for spending down assets. There is nothing necessarily wrong with that but it’s tricky. The last thing you want is to go through all your money by the time you are 75 and spend the rest of your life in financial fear and anxiety.
Your plan will tell you if you are on a safe path or not. If you run the risk of running out of money before you run out of life, your plan will alert you now. It will also identify what you need to do differently in order to have a more cheery potential outcome.
Your assets grow over time based on how you invest and how much you add to them. Your financial plan shows you what is likely to happen to your assets over time based on your decisions about investing and saving. If you like what you see, great. If not, your plan will make it clear what you need to change to have a better projected result.
Retirement is an important financial objective but it probably isn’t your only financial goal. You may want to put aside money for your children’s’ college, buy a house, travel more or whatever. A good plan helps you achieve those things.
It does that by making allowances for those special expenses. If it looks like you won’t be able to afford some of those goals, it’s better to know about it early when you can do something about it. Again, the plan provides those alerts and suggests alternative courses of action.
Other benefits of having a financial plan
I started this post by suggesting that a financial plan answers questions. In so doing, it give s you control over your finances. And it tells you what you can do in order to improve your situation now and down the line.
It takes cloudy feelings and turns them into specific action. For example, you might be walking around feeling like you need to save more but you may not know how much or how to invest that money. After you run your plan, you’ll have your answer. You may not know how much you should be saving or how much it costs you to live now but you will know after you do your financial plan. You may not know if you’ll ever be able to retire.
Your plan will tell you if you can or can’t, when that can happen, and how to make it your reality.
You can run a financial plan but that’s no guarantee that everything will work out of course. Your results will vary. Nonetheless, the plan empowers you to do something about your situation. It tells you exactly what to do and it provides an early warning signal.
With all its imperfections and limitations, I can’t think of a more important exercise for people who work hard now and really care about their financial future. Can you?
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