Financial rules of thumb are a great catalyst for beginner investors. To know how these rules can revolutionize your investment game, read this article!
Rules of thumb exist in order to make our lives easier. Their reliability can be traced from the fact that they are based on actual practical and empirical evidence rather than just theory.
Well, isn’t that the kind of accuracy and reliability that we wish to have while doing financial planning?
Financial planning can be a hobby for someone and may get a little hectic for someone else. There are a million ways to do it but what works the best for you can only be created by you.
Some people focus primarily on saving, some are aggressive investors, some just buy a life insurance policy and call it a day while others may altogether run away from it! Whatever it may be, the fact is that we all have different financial goals and commitments and therefore, a personal touch to financial planning.
So if you are all set to create your own financial portfolio, here are some rules of thumb to assist you!
Basic rules of thumb for different financial strategies:
1. The asset allocation rule of thumb- how much equity should you have
The rules associated with asset allocation are profoundly used in the investment world. As per this popular rule, the equity percentage in your portfolio should essentially be 100 minus your age. For example, if you are 40, 40% of your investments should ideally be in debt and the rest 60% in equity.
Note: However, this rule doesn’t take into consideration your risk profile, risk appetite or any financial goal. If you find this difficult to abide by, just adjust it as per your financial ambition and stability.
2. How much of an emergency fund should you create?
An emergency fund is your saviour during times of emergency. Human life is full of unpredictable circumstances. You may suddenly come across a situation where a large sum of money is required, say for your child’s admission to a prestigious institution or some unforeseen medical emergency.
For these types of situations, 3 to 6 months' worth of monthly expenses should be kept aside as the emergency fund. If you are a retired person, you must create an emergency fund that is worth 1 year of your necessary expenses since there would most likely be no other source of income with you.
Some rules exceptionally for retirement plans
3. How much corpus should you build?
As per the rule, you must ideally try to save at least 20 times your income saved for a retirement plan. In addition, investing in FDs is a good option since they have a very long maturity period.
However, this rule may not be ideal for everyone since situations are quite different now. The rule is essentially based on the assumption of a retirement age of 60 and a life expectancy of 80 years, and a conservative lifestyle- not quite fit in today’s scenario.
Plus, if you have other plans for retirement, like the FIRE lifestyle for early retirement or perhaps to build your own house after retirement, your planning would be very different. It will take a lot of speculation while making investments, and your choices can’t really be conservative.
4. How much investment is enough for a secured retirement plan?
Well, this rule takes several forms depending on the time you start saving for retirement. In case you are a minimalist person who would desire a simple lifestyle and comfort after retirement, 10% of your monthly income can be a good start.
Whereas, if you are keen on getting an early retirement and then going on some adventure spree, you can start saving 20% of your monthly income.
In case you are starting a little late (say in your mid-30s), then you can carefully bifurcate your savings plan. For example, save 10% for your daily necessities, 15% for comfort and maintain a 20% saving component for a dose of escape!
Rules of thumb for effective insurance plans
5. Do you really need insurance? If yes, how much is okay?
No doubt an insurance policy, especially a health insurance policy, is a necessary investment to cope-up with uncertain situations.
As per this rule, one must have bought an insurance policy that promises at least 8 to 10 times one’s annual income. However, this may not be consistent for everyone since insurance policy returns should depend very much on your age. Consider a person of age 30 while on the other hand, a person of age 50- clearly, the younger person requires more money to sustain a long life ahead.
Taking the same case forward, if you buy insurance in your 30s, it can be ideal to get an assured sum of at least 12-15 times your annual income. Whereas, if you are buying at 50, an assured sum equal to 6 to 8 times of annual income would be sufficient. The rest depends on your spending and saving habits.
Rules of thumb consistent with your loan/home/liabilities
6. What should be the value of my house?
The actual rate of any house depends on several factors, like its location or the presence of some exclusive infrastructure in the area. However, this rule suggests a basic value as per your income. Ideally, your house should have a value that is 2 to 3 times your family income.
Say your annual family income is 10 lakhs. Then, as per the rule, you should buy a house in the range of 20 to 30 lakhs- not above it. This will ensure that you are investing in a house that falls within the range of your budget and if you are taking a loan, it will be easier to pay its dues.
7. How much of an EMI is feasible?
Honestly, a 0 EMI is the best answer if it was possible to make big purchases without loans. However, not many of us have access to enough money to buy a house, etc. In these situations, loans come in handy to save the day.
As per this rule of loans and liabilities, your EMIs should not exceed 36% of your gross monthly income. The idea is simple: if EMIs will exceed this limit, it will be difficult to accommodate them into your regular monthly budget.
Also, if you are planning to buy a house closer to your retirement, make sure that EMI for that isn’t more than 28% of your monthly gross income. Remember that you don’t have regular income flows after retirement and therefore, you won’t like an extra burden on your budget.
Rule of thumb for car purchases
8. How much should you spend on purchasing a vehicle?
If you are a car enthusiast, then it might turn out to be your second biggest purchase after a home. Clearly, you wouldn’t want to spend a huge amount that leaves your financial health shaken. Plus, cars are a depreciating asset. Their value starts falling right after the day you bought them!
Therefore, to make a smart purchase, make sure the value of your car doesn’t exceed 50% of your annual income. In the case of a car, sometimes it is better to buy a second-hand model. If you don’t want to do that, then invest in a new one and use it for 10 years and then do the necessary vehicle replacement.
Also, if you are buying a car on a loan, you can follow the special 20/4/10 rule. As per this, the minimum down payment should be 20% with a loan tenure of not more than 4 years and the EMI shall never exceed 10% of your gross monthly income.
Rules of thumb to calculate the rate of returns
9. Rules to calculate when your money will double/behalf
Rule of 72: It is one of the most common rules when it comes to checking the number of years in which your money will double. All you have to do is divide 72 by the rate of returns. When you do so, you will get the number of years. Also, you can reverse this rule to know how much of an RoR will double your money in some particular number of years (say 5).
Rule of 114 & 144: These rules can calculate the number of years in which your money will become triple of its initial value (rule 114) or quadruple (rule 144) at a given RoR. The procedure for these rules is the same as that of rule 72.
Rule of 70: Well your money will not necessarily become double or triple but it can lose value when factors like inflation exist. As per this rule, if you divide 70 by the current rate of inflation, you get the number of years in which your money will become half of its value.
10. Rule 10/5/3 to estimate financial security
This rule gives you some hope for your investments in equities and other securities. As you may there are no guaranteed returns from a mutual fund investment- you can even lose your money.
However, if you believe this rule then it suggests that you can, at the least, expect a return of 10% from a long-term equity investment. Also, there is an expected 5% return from your debt instruments whereas a savings account, on average, gives you an RoR of around 3%.
One thing to remember is that these financial rules can be modified as per your budget, risk profile and financial abilities. Also, while many rules may end up giving you false hope of a financially secure future, real-world analysis before making an investment is essential.
Therefore, the best thing to do is to save and invest regularly- don’t run away from these rules, rather, embrace them as per your needs!
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