3 Intelligent Personal Finance Thumb Rules

Mar 26, 2012

With the plethora of personal finance sites and the wealth of advice floating around on the web, given by your bank, or insisted upon by your advisor, sometimes it helps to take a step back and do a broad check to see if overall, you're doing the right things.

This is where general thumb rules can save you time and let you know if broadly you are on the right track.

But remember, by saving time, you are effectively taking a short cut. Thumb rules are imprecise. They are generalizations, and may not specifically apply to you. For personalized advice, you need to speak with your personal financial planner for a financial solution to your specific situation. So is there an in-between solution for people who don't yet have a personal financial planner and don't want to follow only broad generalizing thumb rules? Yes there is.

This article will show you some lesser known, more precise thumb rules that will still save time, and will be better for your personal finance situation than just a broad guideline. Let's see what these thumb rules are:

• Equity - Debt Exposure & Your Goal Time Horizon
  
  There is a thumb rule that people sometimes follow, which states that your equity exposure should be (100 - Your Age)%. The balance should be in debt or fixed income instruments. So, if you are 30, then 70% of your wealth (100 - 30)% should be in equity.
  
  This isn't completely appropriate.
  
  A 30 year old might have a number of short term financial goals due to a significant life event, such as a wedding, or a first born child, or buying a car and so forth. Having 70% of your exposure in equity therefore would be a bad idea, because there is no capital protection and your funds would be exposed to market volatility. If you need to suddenly pull out money, you might take a loss on your investments.

  The more appropriate and still easy thumb rule is this:

  3 years or less left for your goal = No Equity Exposure.

  
  
  It might seem difficult, but if you have a goal like the ones stated above that is happening within 3 years, avoid equity completely. Think of the people who invested lump sums of money in the Sensex at 20,000 levels. Their money would still be in the red, even after more than 3 years. (Read our article titled To SIP or to VIP - That is the Question to understand the benefits of SIP investing compared to Value Averaging Plans)
  
  So, if your goal is at least 3 years or more away, then consider equity investments, otherwise don't.
  And the longer the time duration for your goal, the more equity exposure you can have. For example, if you have 5 years to your goal, consider 60% equity, 40% debt. For a goal that is 10 years away, consider 80% equity, 20% debt. Your age has very little to do with it.

• Rule of 69
  
  You have probably heard of the Rule of 72.
  It helps you calculate what rate of return it will take to double your money.
  For example, if somebody tells you that by investing in so-and-so product, your money will double in only 8 years, the quick calculation would be:

  Rate of Return = 72 / Number of Years to Double Money
  ...and this calculation would tell you that the product the advisor is recommending should be giving you an annual return of 72/8 i.e. 9% p.a.

  This is quick, but the reason the number 72 is chosen is because it is easily divisible by many denominators and because it is close enough to the real number, which is 69.

  So the more accurate rule is:

  Rate of Return = 69 / Number of Years to Double Money

  
  The Rule of 69 will give you a more accurate answer to your double-your-money question. In the example above, if something is doubling your money in 8 years, then 69 / 8 gives you 8.625% p.a. i.e. lower than 9%. Consider taxation eating into your returns, and suddenly this double-your-money-in-8-years product doesn't seem very attractive, does it?

• Save and Invest at least 25% of your salary
  
  A rule that many people follow is to save and invest 10% of their incomes. In no uncertain terms, this is not enough.
  
  Remember this: the more you save now, the more your money compounds. And if there's one magical thing about finance, it's the power of compounding. You might have to cut back on discretionary expenditures to save 25% of your salary, but in the end it will be worth it. (Read our article titled Do You Have Your Own Budget.)
  
  So aim for at least 25% of your take home salary being saved and invested. Invest it as per your goal time horizon (see Rule No. 1) and as your salary increases, remember to at least proportionately increase your investments.

Conclusion

Thumb rules are, by their nature, imprecise. If you want a completely accurate and personalized financial solution to help you achieve your life goals, your financial planner is the person to talk to. Until then, be careful what thumb rules you follow, and err on the side of caution when dealing with your finances.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.