The Financial Life Cycle
A lot of young people are not aware of what their financial goals ideally should be. Most of them fall into the habit of trading time for money. This contract wherein one person trades their time, money, and effort for an income is called employment and is generally viewed upon favorably by the world. It is considered good to be employed. However, many youngsters make the mistake of thinking that they will remain employed for their entire life. The fact of the matter is that the average life expectancy is now increasing beyond 75 years, whereas an average individual is likely to be employed for about 30 years of their life. Hence, they have to make 100% of the money in only 40% of the time.
In order to help the average middle-class person plan their financial goals, financial planners have developed the concept of the financial life cycle. It needs to be understood that these concepts may not be applicable to very rich or very poor people. Instead, this is the aspirational life cycle of most middle-class people around the world. In this article, we will have a look at the stages that an investor has to pass through.
Stage #1: Financial Dependence
Everyone who is born in this world is financially dependent upon their parents. Most people did not use to make big financial decisions before they are 18 years old. However, nowadays, a lot of middle-class students take college loans in order to further their education and prepare themselves for the job market. It is important to realize that these loans have to be repaid by earned income later in life. Hence, education loans should be taken only if they are financially viable. This is the reason why parents should undergo financial planning training so that they can aid their kids by preventing them from starting their life on the back foot. The objective of the financial dependence stage should be to accumulate minimum debt.
Stage #2: Solvency
Assuming that the students have passed the first stage, they move on to the next stage. The objective of this stage is to remain solvent. This is the stage wherein the individuals have just finished their education. As a result, they get entry-level jobs. These entry-level jobs pay them just enough to maintain a basic standard of living as well as to pay their old debt. It is important that the person maintain solvency during this stage and not accumulate excessive credit card debt because of frivolous spending. This stage lasts for about five to seven years.
Stage #3: Financial Dependence
This stage is where financial planning really becomes important. This is because, after five to seven years, the person is no longer in an entry-level job. Instead, they are likely to be in a mid-management position in the firm that they work in. Hence, their income is significant. Also, this is the stage that most people get married, meaning that two incomes become part of the household. This is a substantial increase from the subsistence existence mentioned in the earlier stage.
However, this stage is also marked by some of the biggest expenses in the life of an individual. This is because this is the stage wherein people buy houses, cars, vacations, etc. A significant amount of money is also spent on the wedding expense.
The most common mistakes of financial planning are also made at this stage. It is very easy for individuals to assume that life will continue the same way. However, for many, it does not. As the age of a person increases, they often have kids. Hence, the education and medical expenses of kids also increase a lot. However, income doesn’t increase proportionally. The end result is that people are left living paycheck to paycheck. About 70% of people spend their entire lives at this stage because of improper financial planning.
On the other hand, if an individual is financially aware and has been planning, they can supplement their own income with passive income because of the investments made earlier.
Stage #4: Financial Independence
This stage is the goal that most financial planners help their clients achieve. This is the stage wherein a person has built so many investments that their lifestyle can be maintained by the passive income generated from these investments. If the person has made financially correct decisions in the past, then this stage is characterized by a situation wherein working is optional. Investors have the freedom to spend their time with whomever they want and work in order to pursue their passions and hobbies. A person who is retiring needs to be at this stage at least.
Stage #5: Financial Abundance
Financial abundance is for a very small number of people. At this stage, an investor has so much money coming in via passive investments that they do not care about money too much. Instead, their decisions are motivated by the need to leave a legacy behind. Most people associate this stage with billionaires such as Bill Gates and Jeff Bezos. However, this is not true. There are several people whose net worth is a few million. However, because of their frugal lifestyle, they are at this stage.
Hence, the financial planning lifecycle encompasses the entire lifecycle of a person. There are different financial goals that need to be pursued at different stages. This is the reason that financial planning should be taught at the teenage level before any major life decisions have already been made by the individual.
Authorship/Referencing - About the Author(s)
The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Importance of Personal Finance
- Process of Financial Planning
- The Financial Life Cycle
- Three Types of Income
- Misconceptions about Personal Finance
- Macro-Economic Factors and their Effect on Personal Finance
- Going From Financial Goals to a Financial Plan
- Components of a Financial Plan
- Personal Financial Statements
- Advantages and Limitations of a Budget
- Ratio Analysis in Personal Finance
- Dollar-Cost Averaging
- Pitfalls of Dollar-Cost Averaging
- Value Averaging Method of Investment
- The Rent vs. Buy Decision
- Financing Your Home
- Fixed-Rate Mortgage vs. Adjustable Rate Mortgage
- The Phenomenon of House Poverty
- 5 Step Retirement Planning
- Retirement Basics: 401K Plan
- Retirement Basics: Roth IRA
- Auto Loans and Personal Finance
- Earnings Power in Personal Finance
- Personal Financial Planning For Small Businesses
- Common Pitfalls of Tax Planning
- Zero Based Budgeting System Using Envelopes
- The Concept of Financial Freedom
- The Financial Independence Retire Early (FIRE) Movement
- How Do People Save Large Percentages of Their Income?
- Rich Dad Poor Dad Philosophy
- The Pay Yourself First Principle
- Personal Finance Lessons from Rich Dad Poor Dad
- Estate Planning in Personal Finance
- 7 Personal Finance Mistakes to Avoid