Financial planning is the intentional and purposeful pursuit of your life path – the things you wish to achieve, the places you want to go, the life you want to live, the freedom you want to have – by ensuring those things are prioritized and that you have the financial ability to execute them. There are many ways to do all that – and everyone needs to choose which way is best for them. For some, using a financial advisor or a financial planner could be the best approach, for others – DIY (do-it-yourself) is highly preferred. Whichever way you choose to go, having a plan brings you such important benefits that once you start thinking in that framework and managing your money according to such a plan, you might even wonder why you did not do it earlier.

The content of this post does not constitute financial advice. It is intended for educational purposes only.

what is a financial plan?

The industry will give you a formal definition of a financial plan – namely, that it is a document created as part of a complex consulting process with a professional planner or advisor, which includes your goals, circumstances, needs, as well as strategies and approaches to achieve those by using tools such as investment planning, tax planning, retirement planning, estate planning, etc. I encourage you to think about it more broadly and loosely, especially if you are doing it alone. Yes, a comprehensive financial plan would cover all those things (in the chart below you will see an overview of all key components), but it is essentially a forward-looking tool to organize and manage your financial life in all its various aspects.

Over your lifetime, your goals and needs will evolve as you transition from one stage to another with its own specific characteristics. This means changing circumstances and changing options for you and your money. Therefore, a financial plan is not a “do-it-once-and-forget-about-it” thing, it is certainly not static. A financial plan is also supposed to help you cope with various situations and challenges – it is not just something that imposes strict limits on you, like: “No spending on this!” or “Do not borrow money, ever!“. A proper financial plan has built-in flexibility that helps you respond to surprises and shock scenarios and even gives you guidance as to what you can do when you get off track with your goals.

There are some misconceptions about what a financial plan is – some think it is essentially just an investment plan and others – that it is a budget or cash flow plan. Those are just individual elements – and they are linked together into a coherent consistent whole. The planning process examines one’s financial situation and ambitions for the future, it is not solely about the strategies and the actions. In that sense, another misconception is that only the wealthy need or can afford a financial plan – which is also incorrect. I would even argue that individuals with more challenging financial situations, with much lower levels of income or wealth, with much more limited resources, have a much bigger need for the planning process’s systematic approach to determining the most optimal resource allocation, to build wealth and achieve one’s financial goals.

The dynamic nature of the plan means that it can and should incorporate:
– strategies and actions relevant for each stage of one’s life and dependent on one’s goals for each stage;
– alternative approaches to achieving each goal depending on expected probable changes in one’s circumstances;
– risk analysis for each stage and, ideally, a scenario analysis incorporating the alternative paths and approaches;
– worst-case stress tests to evaluate whether and which goals might not be met if unforeseen developments hurt your income or cause a significant jump in expenses or losses on your portfolio.

The flexibility of the plan should allow you to adapt. You may indeed feel that the plan imposes constraints in certain areas of your life, but this is also where professional advice could help in finding better alternatives, or where you might need to think out-of-the-box about spending optimization and additional income sources. The plan should be as realistic and as feasible as possible and should not put you in a situation where you have to sacrifice so much that you feel demotivated to adhere to it or you feel like you have to give up on your goals or other things that you value.

The life-stage breakdown presented below is an indicative view of when each component might be the most logical to focus on, but in general, the majority of the planning components need to be covered continuously throughout one’s life. The reason is that each component to various extent involves steps that need to be taken earlier in life and then consequences or follow-up steps that come later in life. The exact periods where the emphasis is put on each component can vary depending on individual goals and circumstances, and so will the relationship between income and risk-taking capacity shown below. This relationship need not be like this for everyone but for a typical person, the ability to take on more risks is higher in the early stages of life and progressively declines over time as human capital is depleted and the ability to recover from large losses or make more changes is becoming more and more limited.

the most important benefits of having a financial plan

1. Systematic and consistent progress toward your goals
A complete and detailed plan is essentially a roadmap for achieving your goals. Not only does it give you a breakdown of the steps and interim milestones and targets, which makes adherence to it easier, but it also provides a structure with embedded prioritization that helps you organize yourself better and motivate yourself to get there through small increments. The plan is also a tool for tracking and monitoring where you are – and assessing whether you need to make changes. It is both a reality check for you – and an incentive to follow it and do better over time, e.g. increase your savings and investment rate, or minimize some categories of discretionary spending.

2. Factoring in the unplannable
By incorporating risk assessment and scenario analysis into your plan, you can be relatively better prepared for some unforeseen events. For instance, when emergencies hit, you would be able to react better by resorting to insurance or social security benefits, or by utilizing a proper emergency fund that you have accumulated for such occasions yourself. A plan can also prevent you from making decisions based on emotions, fear, or panic, which can lead to disastrous consequences for your money. When you have a set of possible actions for various types of situations or market developments, you can overcome impulses for irrational acts. You will also be able to evaluate the impact of such events and volatility on your finances and decide whether you need to protect yourself.

3. Better overview – more flexibility
When creating a plan, you will need to review your financial situation in its entirety – all cash outflows and inflows, assets and debts, goals, needs, constraints, preferences, and values… The process is challenging and makes you evaluate yourself in the context of your interaction with money and future plans, from all perspectives. But there is a huge advantage to going through all that – you will have the full picture and a comprehensive understanding of your outlook. This is immensely important if you want to make appropriate decisions. But it is also key for you to be able to manage what happens in the future – you will be more comfortable when new spending needs arise because you will know precisely what you can handle. You will know how much you can invest, how much you can afford to spend on fun, or whether you will be able to buy that new appliance you need so much. Sometimes, in this process, you could even discover hidden buffers you didn’t know you could resort to, and even surprise yourself positively with how much more you can do than you expected.

4. Well-informed and goals-aligned investment decisions
When you have a complete understanding of your circumstances, goals, and, most importantly, risk tolerance, you will avoid adding instruments to your portfolio or choosing investment vehicles that are unsuitable for you. Sometimes our investment decisions could be swayed by the hype of everyday news and announcements, even though the company names and instruments appearing there might not be fitting for us at all – they could lead to concentrations or exposure to factors and volatility that we cannot tolerate. And it is not solely about picking individual investments – the availability of this information and awareness of key tolerances and goals helps us pick the right strategy and the optimal asset allocation. As a result, we can build better portfolios for ourselves and rebalance them accordingly over time.

5. Better financial and mental health
The plan enables you to be in control, which can provide you with confidence. It also motivates you to significantly improve your financial habits in your pursuit of wealth and your goals. As you can see in the survey results below taken from Charles Schwab, for US respondents the effect was a considerable improvement in financial habits. This is the key to better managing your liabilities and avoiding having to go into debt regularly or when you are faced with emergencies. Consequently, you will feel less anxious and will be much less stressed when the unexpected happens as you will be prepared to react and have buffers. This is a huge mental health benefit – risks and challenges emerge all the time and having the mental framework and financial capacity to deal with them can be a life-changer.