Are we doing the right things when it comes to managing our finances? Ask yourself five questions to know if you’re on the right track.
1. Do I have sufficient emergency funds?
Each one of us needs to make sure we have sufficient funds to meet our daily expenses. Financial advisers typically recommend that we set aside emergency funds worth at least six to twelve months of our monthly expenses. This rule of thumb varies among all of us, but the right thing to do is to have more emergency funds if we are less confident of our job security or if we have more commitments and dependents.
Monthly expenses in this case refer to the sum required to meet the daily basic necessities. The costs of food and transport will likely form a large part of these daily expenses. Besides the emergency funds to cover our daily expenses, we may have plans that require a large outlay in the next couple of years. For those who are preparing to get a home, we will have to plan for the expenses (which can be used from cash and/or CPF funds), including the deposits, stamp duties, lawyer fees, housing agent commissions (which depend on whether the home purchase is an HDB flat or not), as well as renovation – it goes without saying that all these could add up to a hefty sum.
So if getting a home is in the pipeline, set aside some money beyond your emergency funds in a financial product that is relatively safe and liquid, e.g. money market funds, fixed deposits with a shorter maturity period or shorter-term Singapore government securities (SGS) bonds. Fixed deposits and SGS bonds are seen as particularly safe; in Singapore, the government guarantees all Singapore dollar and foreign currency deposits in banks and other financial companies licensed by the MAS to 31 December 2010. SGS bonds typically have a high credit rating of AAA or Aaa, based on the ratings given by agencies such as Standard and Poor’s, Moody’s and Fitch.
2. Have I planned for my dependents?
Dependents are the people who depend on our financial income. For example, when we start working in our mid-20s, it is likely some of us give a monthly pocket money to our parents. This could be due to our Asian upbringing, where filial piety leads us to give back to our parents, or it could be due to very practical reasons such as the parents earning little, and therefore having to rely on their children’s income to meet their daily expenses.
For people who have to set aside a portion of their salaries for their parents, it is paramount that we have insurance coverage. Insurance plans which cover hospital bills, critical illness, total or permanent disability (TPD), or death, as well as income replacement plans which provide a regular stream of income if the victim is unable to work (due to an accident or an illness, other than the critical illnesses), are important.
They are must-haves in our financial plans as they will ensure a sum of money is given out to meet the medical costs (in the event of critical illness or TPD), or simply to ensure the victim’s dependents have some financial cushion to fall back on.
We must make sure our insurance plans’ sum assured is sufficient to meet our expenses and the needs of our dependents. For example, I know quite a few friends who have purchased their insurance plans after they landed their first job from friends or relatives who work in the insurance agencies. Check out the sum assured of these plans, because the coverage may no longer match your objectives now. For example, if the sum assured is S$100,000, this is likely insufficient to meet our daily expenses, not to mention the medical costs, in the event of a critical illness. In the event of death, dependents would find that $100,000 will not last very long. If we include inflation in the equation, the real value of the sum assured would decline as time goes by. This is why financial advisers often take into account the inflation rate into the amount of coverage we need.
Upping the sum assured could lead to higher premiums, if we stick to whole life policies. The other alternative to whole life insurance policies is term policies. These policies enable us to have a higher coverage for the same amount of premium paid, but they do not have a surrender value – we will receive nothing from the policies if there we terminate them or wait for them to mature, unless the insured event arises.
Typically, insurance policies which combine investments and insurance – investment-linked insurance policies – are not the greatest way to achieve our financial objectives. Killing two birds with one stone may seem like a good idea, but aiming to achieve both investment returns and insurance coverage with one product would typically mean one of the two objectives is not being fully met. The cost is likely to be less effective as, say, investing in a regular savings plan or RSP (solely for investments) and purchasing an insurance policy (for whatever objectives we have in mind, e.g. coverage for income replacement, critical illness, TPD and death).
Making sure we have the right insurance policies will ensure there is a lifeline for the victims and their dependents to ride out the difficult periods.
3. What commitments do I have?
The more financial commitments we have, the more we must ensure our financial plans are in order.
For example, for those of us who have bought a property, we must be sure that we have insurance to cover the mortgage instalments in the event that an unfortunate event occurs, e.g. inability to work because of an accident or poor health, ongoing medical treatments or death.
For parents of young children, there is a need to review your insurance plans, to make sure that there is sufficient coverage in the event that one or both parents pass away. Furthermore, it is crucial to plan for the children’s education costs as early as possible.
Endowment plans have been a rather popular option when it comes to planning for education needs. These plans require the parents to save a sum of money regularly and they will provide a sum of money by the time the child starts university. There is an additional element of insurance in the endowment plans too. However, if the parent has a long-term investment horizon and is confident he/she can stick to an investment plan, the other option is to invest into a portfolio of stocks and unit trusts, with the aim of beating the returns of endowment plans.
4. Do I invest in a disciplined way?
2008 was a lesson to many of us and it was the very first time many of us saw markets tumble so fast and so furiously in a matter of months. To describe last year as shocking would be an understatement. Portfolios tanked and despondency could have led us to lose faith in investing. But that is a mistake, especially for those of us who have an investment time horizon which is at least three years or longer.
Business cycles turn up and down. While markets currently remain mired in uncertainty, there will come a time when markets pick up. Some economists are predicting an upturn in the second half of this year, while the more cautious ones believe the recovery will only happen in 2010. However, these predictions should not stop us from sitting on the fence. Markets are forward-looking and typically move ahead of the economies.
If you have spare funds to invest, this is a good time to nibble back into the markets. A regular savings plan (RSP) would be a disciplined way of achieving that. An RSP requires us to invest, with a total disregard to whether markets are rising or tumbling or moving sideways. It requires us to be disciplined in that sense, but it also makes great financial sense. Over time, an RSP allows us to dollar cost average – meaning that the average cost of our investments actually declines, enabling us to enjoy better returns.
For example, during the last few months, an RSP would have enabled us to accumulate more units of a fund, because of declining stock or unit trust prices. When markets rise again, these additional units will make a positive difference. The same applies when markets rise. We buy lesser units – which is clearly not a good thing because we want more – but it also means we are not tempted to buy more when markets shoot up. Often, even the more rational investors fall prey to their greed and they keep buying when markets rise, even when financial measures such as the price to book ratio scream ‘sell’.
5. Do I review my financial plans?
We must review our portfolios periodically, e.g. once every six to twelve months.
For example, if we are a balanced investor (in between conservative and aggressive), our allocation between equities and bonds could be in the region of 60% in the former and 40% in the latter. What would have happened to the portfolio if that was the asset allocation at the start of 2008? Bonds – based on the performance of global sovereign bonds – outperformed equities – based on that of global equities – last year, meaning the asset allocation between equities and bonds would no longer be 60:40; it could have shifted to 50:50, as a result of the better performance from the sovereign bonds.
A 50:50 asset allocation would mean our portfolio is teetering toward a moderately conservative risk profile, rather than a balanced one. Rebalancing is the trick here as it requires us to sell our bond units and buy back equity units, so that the equity to bond asset allocation returns to 60:40.
Our research team usually recommends a different asset allocation every year, depending on the outlook for the different asset classes. For 2009, in the case of a balanced investor, the recommended equity to bond asset allocation is 70:30, because of our research team’s preference to equities, relative to bonds.
For those of us who are very conservative when it comes to investing, it doesn’t mean we should not invest altogether after the events from 2008. There are funds which are less risky, as reflected in financial measures such as the volatility data or the Sharpe ratio. Typically, bonds are less risky than equities, but even within these two asset classes, there are differences in risk characteristics too. For example, within the bonds universe, investment grade bonds are seen as less risky than the high yield ones, while the sovereign bonds from the developed markets are seen as less risky than those issued by the emerging markets.
It is never too early or too late to take charge of our finances. The key thing here is that all of us must plan because if our financial plans are not in order, a lot of our other plans in life could well be in jeopardy. For investments, take charge by making sure you stick to a disciplined way of investing which is devoid of emotion-driven decisions. When it comes to insurance, find a financial adviser who can give you a comparison of insurance plans from as many different insurance companies as possible. You may find that company A’s plan suits some of your needs better, e.g. income replacement, but company B’s plan may be more appropriate to cover critical illness – so don’t analyse the plans from one insurance company only. Remember to check out the fine prints, when it comes to investing or purchasing an insurance plan. For example, critical illness insurance plans typically cover only 30 types of illnesses (which vary from one company’s plan to another), and the definition for TPD is very strict.
Summary: Five ways to take charge of our finances
Sufficient emergency funds to cover our daily expenses over a period of at least six months to one year
Sufficient insurance coverage to cover unforeseen circumstances, including inability to work, critical illness, hospital bills, TPD, death
Sum assured must be sufficient to meet dependents’ needs and other financial commitments we have, e.g. mortgage instalments, children’s education plans
Have an RSP, which ensures we stick to a disciplined way of investing
Rebalance our investment portfolios every six months to one year to ensure their asset allocation is in line with our investment objectives
Understanding Risks & Returns of Bonds
Our Asset Allocation Decision for 2009