Have You ever used thumb rules for financial planning, investment or any other quick decision in your day to day life? These quick to calculate formulas are useful for many situations we face in our daily life. For example how we calculate quickly how much time it takes our investments to double at a specific rate of interest? or How many times of life cover we should have? This article gives some idea on how to use some of these for quick determination of these values approximately. It is not substitute for personal financial plans but will give a quick idea of what can be expected in such a situation.
The wikipedia definition of thumb rule is
A rule of thumb is a principle with broad application that is not intended to be strictly
accurate or reliable for every situation. It is an easily learned and easily applied procedure for approximately calculating or recalling some value, or for making some determination.
As can be seen thumb rules for financial planning or investments or any other activity in life can be approximate values that can be calculated and used at a fraction of time. I must caution that in the places where precise results are required these must not be used. These rules are very helpful when you need a quick calculation like
1) At X interest rate how many years it takes to double or triple my money?
2) How much percent should I invest in equities as a part of my asset allocation?
3) How much money I can withdraw every year from my retirement corpus to sustain for X Years? etc.,
These are most common questions faced by many investors in day to day life. At the cost of repetition I wish to clarify that these investment thumb rules are not substitute for financial planning and advice from advisers. They can be used as a start point in designing financial plans or goals. In fact doing such thumb rule calculation before meeting any financial adviser will be of great help as more realistic goal setting and financial plans can be constructed with such preliminary idea.
Let us see some of the most widely used thumb rules in the field of investment and financial planning.
7 Thumb Rules For Financial Planning And Investments
1) How much time it takes to double or triple my money? (Rule of 72 and 144)
This is the most common situation we face in our daily lives. With so many financial instruments ranging from liquid funds to equity offering different rates of return one must have an idea by investing in them how much time it takes to double or triple the capital amount.
Rule of 72 says how much time (in years) our money will double at a given interest rate. In other words if we know the rate of return we can calculate without using any excel sheet or financial calculator when our capital will be two times. The rate of return can be known one like on FD’s or expected return for investments in equities and other mutual funds. If rate of return is 12% then as per rule of 72 it takes 6 years to double the money.
=> 72/12 = 6 Years
It is 6.116 years if we calculate with financial calculator or excel sheet. You can see its approximate value but good enough to calculate if no such tools are available for calculation.
We can also calculate approximate rate of interest we get on our investment if we know how much time it takes to double our money. For example if our money doubles in 4 years, then the approximate rate of interest on that instrument is 18%
=> 72/4 = 18% (18.92)
=> 72/8 = 9% (9.05)
The values in brackets are calculated using Casio FC 200V financial calculator. As can be noticed for higher interest rates or shorter duration the error is more.
Rule of 144 is similar to above rule and it can be used to calculate what should be the rate of return if our capital investment has to be tripled. As in the above example at 12% rate of return our investments will triple in 12 years.
=> 144/12 = 12 Years
2) How much Percent of my investments should be in equities?(100-present age)
By now most investors understand the importance of asset allocation in proper assets for optimum risk reward. Many financial planners stress the importance of having a proper asset allocation strategy before one consider investing for their long term goals. The rule of 100- present age in years indicates how much one should invest in equities. If we follow this rule for a 40 year old person, ideally he should be investing around 60% of his investments in equity and equity related products. But its not fit for all. Every investor has his unique needs, goals, risk profile and this must not be only criteria for asset allocation while investing. In recent times many financial planners advocate to use 120-present age rule to better plan for increase in average life expectancy and inflation. In practice this depends more on investment horizon of the investor and other concerns.
3) What will be future buying power of my money? Rule of 70
We all experience depreciating power of buying power of money as time passes. Inflation effects our future buying power and it is the reason our 1 rupee will not have same buying power over a period of time. This rule will let us calculate how much our money is worth after X years of time after taking into consideration inflation. In other words what is the inflation adjusted value of our money at that time in future?
This rule of 70 says if we divide 70 by current inflation we get the value in years at which time the value will be half of present value. If we have 100 rupees today and inflation is 5% then, then inflation adjusted value of our 100 rupees after 14 years will be 50.
4) How much % of my Income can be used to repay loans?
In today’s society we hardly find one without any loans to pay either it personal loan or housing loan. Every day we get offers in our mail box or mobiles with attractive loan offers with lowest (??) interest rates and discounts. But going for that loan without assessing its effect on our finances can be disaster. Then how much of gross income we can spare for repaying our debt. What the rule of 28/36 says is, the maximum debt including car loans, personal loans etc can be UP TO 36% of our gross income. For house loans etc it should be maximum of 28%.
5) Pay Yourself First or 10% Saving rule.
This is one of the basic rules of investment one should follow if planning for long term wealth accumulation. Usually we are in the habit of allocating our income for expenses first and if anything is left after that we think of investments. This rule requires you to reverse that equation.
What we follow usually is
Income – spending = Possible Savings
What this rule says is
Income – Savings (atleast 10%) = spending
This wealth creation rule is populated by George S. Clayson in “The richest man in Babylon”. This is the basic logic why most financial planners advise to have maximum investment possible through Systematic Investment Planning. Most people do not like to fail in their obligations, including in investments in SIP. So by starting investment through SIP, one can easily follow the above rule as one can spend the amount left after accounting for their monthly contribution for SIP. This is the simplest way to start a disciplined way of investing and plan for long term goals. Without such investments it is not possible for many people to cater for their long term requirements like own house, children education or retirement corpus.
6) How much Insurance I should have for my family?
The minimum life cover one should have is atleast 10-15 times of Annual income after subtracting personal expenses and personal taxes on that income. This number will be unique for each individual depending on family life style, income levels, working status of spouse, needs of children etc., But as a rule of thumb in financial planning one can consider 10 times of personal contribution to family as life cover. Also for taking term insurance policy this math will be useful to see if one has sufficient life cover. Any life insurance cover proposal above 20 times may be viewed with suspicion by underwriters.
7) The Balanced Money Formula Rule Or 50-20-30 Rule
This thumb rule for financial planning is very vital for financial health of any household. If followed properly one can achieve their financial goals quite comfortably in long term. This formula can be best applied when one is not under heavy debt or in special situations. In other words balanced money formula is for people without any special financial situations.
The rule says if a person is earning 100 rupees, he can spend a maximum of 50 rupees for all basic necessities like food, shelter, clothing etc., Atleast 20 rupees should be set aside for investments in financial products for long term financial goals like retirement etc and it includes payment of debt also. The remaining 30 rupees can be spent on life style expenses which are discretionary in nature. It can be followed easily if one allocates minimum of 20% for investments.
As mentioned earlier too, these thumb rules for financial planning are not substitute for personal financial advise. These are best used for quick and approximate values only and should not be relied entirely for investment purpose. The reason is each individual is unique in his / her requirements, risk profile, income levels, life style, goals and no automated rule or plan can substitute a personal and customized advice.