In life people want shortcuts – I think that’s the reason rules of thumb find someplace in one life. These thumb rules for financial planning are very basic & not at all full-proof as the requirements of 2 different people can never be the same. They can just give you some idea but important financial decisions should not be taken on basis of these. Editor of The Journal of Financial Planning (US), once noted that “Rules of thumb are for people who want to decide things without thinking about them.” But still, it will be unfair to suggest ignoring all of them.
Saving & Thumb Rules For Financial Planning
1. What should be my asset allocation or how much equity should I have?
This is the most common rule of thumb which is used in the investment world. The rule says Equity percentage in your portfolio should be equal to 100 minus your age or in other words, debt should be equal to your age. For eg if you are 30 you should have 30% of your investments in debt & 70% (100 – your age) in equity. This doesn’t take care of risk appetite, risk tolerance, or how far your goals are.
2. How much emergency funds I should have?
Emergency Fund helps people in case of a sudden loss of income, medical emergency, etc. The Thumb rules say one should have an emergency fund equal to 3 to 6 months of monthly expenses. You can keep it at 3 months if you are a government servant but in the case of a private job or profession, you should keep it on the higher side of the range. Make sure you don’t use this amount for day-to-day needs/wants. For a retired person, an emergency fund should be equal to 1 year of expense.
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Retirement rules of thumb
3. How much money will I need in retirement or how much corpus I should build?
You should have 20 times your income saved for retirement and plan to replace 80 percent of pre-retirement income. But here retirement means retirement at age of 60 & life expectancy of 80 – and a conservative lifestyle. But now things have changed & you would have dream/planned a lot of things for retirement.
4. How much do I need to invest every month to achieve my retirement goal?
“Indians are great savers” sorry “Indians were great savers”. The new generation is in some different mood they would like to enjoy the present & have no idea about future. If you have just started to work & would like to have a very simple lifestyle & retirement at age of 60 you can do it with saving (read investing) 10% of your income. If you are planning for an early retirement start with 20% savings. Another rule says if you are in your early 30s Save 10% for basics, 15% for comfort, 20% to escape. If you are late by decade add 5% more in each category.
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Insurance rules of thumb
5. How much insurance should I have?
Here insurance means insurance. The rule says one should have a sum assured of 8-10 times of his yearly income. I think this rule is far from perfect but still can be used as starting point. This does not take care of any of your goals, liabilities & even complete expenses. Some modified version of this rule says that if you are in your early 30s insurance should be 12-15 times your annual income & if you are in your 50s take 6-8 times.
Loan/liability/home rules of thumb
6. How big should be my House?
The value of a house should be equal to 2-3 times your family’s annual income. So if you & your spouse are earning a total of Rs 20 lakh – you should buy a house in a Range of Rs 40-60 Lakh.
7. Maximum EMI that I can have?
Ideally, 0 will be the best answer but a few of the big assets like homes require some loan to buy them. Experts agree that your EMIs should not be more than 36% of Gross Monthly Income at any point of time. It should be even lesser when you are close to your retirement. If you want to talk about home loan EMI, it should not be greater than 28% of your gross income. Now TENURE of loan is missing here – for tenure read No. 6 & 8 rules of thumb.
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8. Rules of thumb for buying a car
This is one of the biggest purchases after your home. And this is a depreciating asset – today morning you purchase a car for Rs 10 lakh & by the evening it will be worth Rs 8-9 Lakh. After 5 years it will not be even of half-value but still, you keep buying cars regularly – buy at 10, sell at 4 & lose 6. (repeat the cycle) There are few rules that you can follow:
- The value of a car should not be more than 50% of the annual income of the owner.
- Purchase a used car or buy a new & use it for 10 years.
- While buying a car with a loan stick to 20/4/10 – Minimum 20% down payment, loan tenure not more than 4 years & EMI should not be higher than 10% of your income.
Rate of return Rules of Thumb
9. In how many years my amount will double?
It’s a very simple & most common rule – if you divide 72 by rate of return you will get the number of years in which your money will double. For Eg. If you expect a rate of return of 12% your money will double in 6 years (72/12=6) & what about if the rate of return is 8% – 72/8=9 years. This can also be used in reverse order at what rate your money will double in 5 years – 72/5=14.4%
Rules similar to the rule 72:
Rule of 114 & 144
These can help you in how many years your money will be triple (114) or quadruple (144) at some rate of returns.
Rule of 70
You know it or not but inflation is your biggest enemy – the rule of 70 will tell you in how many years the value of money will behalf. You just need to divide 70 with the rate of inflation so if the rate of inflation is 7% – 70/7=10 years. So in 10 years, your Rs 100 note will be worth Rs 50.
10. Rule 10/5/3
This is a US rule of thumb which says in long term you can get 10% return from equity, 5% return from bonds (let’s say FDs) & 3% from the t-bills (liquid funds – these returns are more or less close to the range of inflation). Indian economy is growing at some different pace & even inflation numbers are different. Can we safely say if inflation is 6% (t-bill rates) we can get 8% from the fixed deposits & 12% from the equity or in other words – in long term equities will deliver twice the return of inflation? Try combining Rule of 72 with this rule – you will get some amazing numbers.
Sometimes Rules of thumb will give you a false sense of security or wrong guidance – so take them with a pinch of salt.
This article also got published in Financial Chronicle – Thumb Rules for Smart Financial Planning
If you heard of some other rules of thumb related to money/finance – must share. Also, share your personal views/experience on any of the above rules.