Matrix for Personal Finance Planning

Rationale

As I was working on a long term planning project, I came up with a matrix to put various initiatives in perspective. It suddenly dawn on me that I could apply that matrix I developed to personal finance planning. I promised my friend to blog on it, so better keep my promise :).

Personal Finance Planning Matrix


The above shows the personal finance planning matrix I've created for a typical, non-financially independent individual like myself, still slogging to make ends meet. Basically, annual income can be spent or set aside for future use. Spending is typical a reaction to a need or want and hence 'reactive' versus saving where money is set aside for future use, i.e. pre-empting future rainy need.

Risk provides another dimension to consider when spending or saving. Merely spending on needs make life boring and meaningless while merely savings lose out to inflation. Thus inducing the individual to pamper oneself with some discretionary spending on wants. For the more adventurous, dabbing in some investments for higher returns.

Self-profiling

Before one consider how much to spend, to save or to invest and much is enough, how much is too much, one could consider using the matrix above to put things in better perspective. The following shows a annual budget profile for an individual, drawing some 14 months salary during a typical, non-recession year:


By looking at his or her profile, one can easily come to conclusion whether he or she is comfortable with the distribution, in terms of months of annual salary actually used in each section.

One potential contention or confusion is differentiating between 'need' and 'want'. Since each individual have different value system (i.e. what is important to one may not be important to another person), differentiating between needs and wants need not be a painful exercise, just allocate things one can do without into wants.

How much is enough?

To answer the question of under or over allocation in each section, one can take a stock of his or her current status:

The above chart assumes an individual currently had 6 months of savings and 12 months worth of investment (current liquidatable value equates 12 months of gross salary). Thus in times of crisis (loss of job or can't work), he or she can easily survive more than a year (assume investment value plunges by about 50%). But is this enough? With his or her financial profile visible now, it is up to the person to decide. e.g. "am I comfortable with 6 months savings?"

Setting a target

One can now set a long term, say 10 years, target of his or her financial position:

By saving only 2 months of salary (and not spending from that pool of funds) and investing only 1 month salary, the accumulated pool amounted slightly over 3 years (assuming investment give about 5% annual returns).

Assuming the individual is not satisfied with the above 10 year situation, one can easily set a comfortable target in terms of accumulated savings and investment and work backwards, invariably having to spend less and save/invest more.

Where to place insurance?

A few (several) words on insurance before I close this article, I see insurance as a service to help one take care of unforeseen financial consequence one is unwilling or unable to afford. Thus if it is a service, it must be an expense. If such a service is a need, then it should go into the 'needs' spending section. However, one point of contention arises because today's insurance products are typically very much convoluted with investment components. Investment is a pre-emptive product meant to generate returns for the risk involved.

The fact that many life policies provides insurance coverage (expense) yet provide surrender value above total insurance premiums paid over the years (returns) once the policy matures, depends heavily on investment returns that is far from certain. The underlying assumption is that the investment component of the life policy generates sufficient return to cover insurance expenses (insurance company's expenses + insurance agent's commission) and insurance premium paid by the person assured. When the investment component does not perform as well as planned, the assured will be quite disappointed to learn his or her policy have not 'break even' after paying the premium for decades. It would have been better to separate the two, i.e. buying term policies and investing the 'excess' premium separately.

In conclusion

It is quite difficult to plan one's route or know where one's going without a map. The matrix above provide such a map to locate oneself, and the destination one hope to go, and plan the route accordingly. Charting for myself, I'm happy to see my current location and see that I'm going in the right direction. Hope this is helpful for you too.