In my last article, we discussed the need to create a financial plan. The end goal of this is to create a sustainable passive income from your accumulated assets. This is what is commonly known as “financial freedom”.
But what exactly is a financial plan? We have already defined the target as being financial freedom by a certain age. But a financial plan is more than a target – it is a road map on how to get to that target. It needs to take into account as many scenarios as possible which could potentially derail you, and put in place precautionary measures. This allows you to reach your goals even if the worst-case scenario befalls you.
So where do you start?
The first thing you need to do is work out what your current monthly expenses are, and how much passive income you need to create from investments to equal that. This sets a clear target to focus on.
The next step is asking yourself how you are going to achieve that level of passive income.
Finally, you need to analyse the things that could potentially stop you from achieving that goal.
This is the easy part. Add up your monthly living expenses, and in a few minutes you will have a figure. If you could receive this level of income from your passive investments, then you are financially free. Essentially, this is retirement. However, we all know that living expenses increase every year due to new additions to the family, changes in lifestyle, or simply the rising cost of living (inflation). Thus the best way to address this issue is to look at your financial target and escalate it by 7% (roughly the average annual rate of consumer price inflation in South Africa) per year. For example, if my target is R20 000 per month, this equates to R240 000 per year. If I escalate that by 7% per year, it means that next year I will need R256 800 to maintain the same purchasing power and standard of living.
How to generate passive income
This is the tricky part. Passive income is simply the fruits of investments you have made that pay you a recurring income, without decreasing the value of the investments. In a perfect world these investments would keep paying you forever. Sounds beautiful, right?
In reality, building a sizable passive income stream takes a phenomenal amount of hard work, timing, business acumen, investment savvy, luck and most importantly: time. The point I’m making is that if you want to be able to retire one day, you better get investing ASAP.
What are the best ways of generating a passive income? There are many, but the most well-known form is simply contributing to your personal retirement annuity or through a pension/provident fund at your place of work. While these forms have their merit, and are a great way to reduce your overall tax liability, they cannot be your only provision for retirement. Unfortunately, the complacency trap that most people fall into is that of thinking that their pension fund will be enough.
There are a host of other investment options which you should consider, all of which have a role to play in your investment portfolio. These include property, stocks, bonds, tax-free investments and even gold and other alternative asset classes.
The most crucial thing to remember though, is to manage risk. Structuring your financial plan correctly, with low-risk investments forming the base of your wealth plan, is an intelligent way to offset unforeseen events which could have significant negative effects on your balance sheet.
Start by planning for catastrophic events such as the death of a breadwinner or a tragic accident which limits your ability to earn an income. These events cannot be offset by saving, 99% of people simply do not have the capacity to save enough money to provide an income in such a situation. Taking out insurance for these events is a prudent way of offsetting these risks.
The next step is to evaluate your long-term investment goals, such as retirement saving. These are long-term investment commitments that are contributed to on a monthly basis, with a defined goal in mind. Once this is achieved, it can then be followed by medium term savings, for events such as sending your children to university. Once you have provided for these needs, you can then focus on discretionary investments with a higher risk, such as trading in shares, CFDs, Bitcoin and other cryptocurrencies.
If you structure your finances in this manner, you greatly improve the robustness of your plan, and are much better equipped to deal with financial turmoil that inevitably strikes us at some point in our lives.
Every person is different, with a different tolerance for risk, investment time horizon, and personal financial circumstances. As such, you require a personalised financial plan. This plan is composed of two parts, namely wealth protection and wealth creation.
In my upcoming articles, I will cover the basics of wealth protection and wealth creation.
Ricki specializes in the field of wealth management with a focus on holistic financial planning. He has a keen interest in the investment fields of property, technology, precious metals and cryptocurrencies. Ricki also holds a Masters degree in Science from the University of Stellenbosch.