Financial Rules of Thumb

Financial Rules of Thumb

 

In my new quest of putting myself out there and making new friends that I can look up to, Saturday was one of the most fruitful days. To give you a background, I graduated in history from one of the country’s best colleges called Lady Shri Ram College in the capital city of Delhi. As the name suggests, it was and remains a girl’s college. The college is old and has a long list of super achievers. A few months back, my ex-boss, another alumnus of my alma mater added me to a big Whatsapp group that aimed to connect college alumni in Mumbai.

 

While I have been shy till now, what caught my attention for this get together was the idea of a session of investment basics by three highly accomplished ladies over a specially curated lunch of Thai food. Personal finance and amazing food? Win-win in my book!

 

The session was interesting, the food out of this world and the conversation scintillating. While the session was in progress, most of the women had a lot of questions. One of them particularly kept asking for the easy way out options like – “How much should I be saving?” “How much should I be investing” “How much do I need to put into equity”? While the presenters told her what I fully believe – that it depends on the person and their circumstances, I still thought it would be a good idea to run past some of the best-known rules of thumb.

 

 

Rule of 72

One of my favorite rules and probably one of the few which can be said to work.

 

Rule

If you want to see you investment double in X years, the required rate of return can be arrived at by dividing 72 by X.

 

Why it Works

One of the first questions in the group was “why 72”? That’s where the magic of compounding is visible at it’s best. The gap between 72 and 100 is filled in by compounding. While the rule gives an approximation, when you need to think on your feet, it works pretty well. Suppose, you want your investment to double in 6 years, you can easily conclude that the required rate of return will be approximately 12%. This is one of the handy rules that actually work.

 

 

10% income should be saved

While there are different variations to the rule, this is often cited as a go-to rule by a lot of people.

 

Rule

You should set aside 10% of your income for as part of your savings.

 

Why it does not work

There are many reasons why this rule should be disregarded completely. Firstly, it depends on your stage in a career. As a beginner, barely surviving in a big city on your own, 10% can look like a mountain to scale. Second, it depends on your stage in life. If you are a single person earning big bucks, it would be a shame to save only 10%. However, if you are just beginning to earn and are also the only bread earner in your family, 10% might still seem like a tough task. One of the best things to do is to list down your goals and save according to those. Read on to know more about why the rule does not work.

 

 

10 times annual income for life insurance

This rule is often used especially because most people do not understand how to calculate their life insurance needs. I didn’t either till the time I started preparing for CFP.

 

Rule

When buying life insurance term cover, it should be worth 10 times your annual income

 

Why it does not work

There are way too many objections to this rule which oversimplifies something as complex as determining a life insurance cover. Think about it: do you think this rule is applicable to a 55-year-old single man?

 

This rule does not take into account the myriad questions required – how much do you spend? How many years do you need the spending for? How much will your financial dependents need and in how many years? For your household financial goals, are you the only bread earner or does your spouse earn too?

 

There are two good routes to check while calculating the appropriate life cover for your family. One is to take the present value of all the income you are expected to earn over your lifetime. The other way is to take into account the present value of all the financial goals and the expected spending for the rest of your life. Calculate the proper life insurance cover for yourself with the free calculators in this post.

 

 

25 times annual expenses at the time of retirement for corpus

This is a rule I came across recently and is a big hit and often touted one, especially among the FIRE community.

 

Rule

25 times the annual expenses that you need at the time of retirement are enough to see you through for infinity. The rule is based on the 4% safe withdrawal rate popularised by Mr. Money Mustache, the pioneer of early retirement which states that you can safely withdraw 4% of your retirement fund every year for the fund to last all your life. When inverted, it can be taken to mean 25 times the annual expenses can then make up that retirement fund.

 

Why it does not work

The safe withdrawal rate depends on the assumptions of two numbers – the rate of return that your fund will generate post-retirement and rate of inflation. Different markets have a different number that can be assumed. As you change these numbers, the safe withdrawal rate shifts and so does your requirement for retirement. Instead, check out the calculator from this post to calculate how much you will need for retirement.

 

 

Invest 100-age in equity

This is another often touted rule for an investment asset allocation.

 

Rule

The rule states that a person should invest in equity in the percentage of 100 – their age. For instance, a 30-year-old should have 70% in equity.

 

Why it does not work

Every person does not have the same risk appetite. Some people can stomach more risk while working to get better returns. On the other hand, while just entering the markets, enough youngsters are not confident of taking any risk. For instance, I was helping my team member make her investment portfolio. After long discussions, she zeroed in on a 60:40 asset allocation in favor of debt funds. The maximum I was able to move her needle was to 40:60 for her to still be comfortable. Her age? 26.

 

As Investopedia puts it, this rule now seems outdated.

 

 

Any other rule of thumb that you hold on to dearly or came to realize through experience is not a right parameter? Let me know in the comments below.

 

 

 

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1 Comment

  1. September 5, 2018 at 2:34 pm

    […] The session was interesting, the food out of this world and the conversation scintillating. While the session was in progress, most of the women had a lot of questions. One of them particularly kept asking for the easy way out options like – “How much should I be saving?” “How much should I be investing” “How much do I need to put into equity”? While the presenters told her what I fully believe – that it depends on the person and their circumstances, I still thought it would be a good idea to run past some of the best-known rules of thumb…Read More […]

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