Top 10 Financial Planning Rules of Thumb

Top 11 Financial Planning Rules of Thumb

http://www.tflguide.com/2011/09/top-10-financial-planning-rules-of-thumb.html

September 6, 2011

In life people want shortcuts – I think that’s the reason rules of thumb find some place in once life. These financial planning rules of thumb are very basic & not at all full-proof as requirement of 2 different people can never be 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 & Investing rules of thumb

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 investment world. 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 fund I should have?

Emergency Fund helps people in case of sudden loss of income, medical emergency etc. Thumb rule says one should have emergency fund equal to 3 to 6 months of monthly expenses. You can keep it at 3 month if you are a government servant but in case of 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 retired person emergency fund should be equal to 1 year of expense.

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 a retirement at age of 60 ; life expectancy of 80 – and a conservative lifestyle. But now things have changed; you would have dream/planned lot of things for retirement.

Another method is to have liquid assets with cash equivalent of at least 100 months of last income for simple normal living and medicare of spouse and self. It is better if the multiple is 120.  These liquid assets should be interest or dividend yielding.

Another simple method:
No. of retirement years....till death of individual and spouse...whichever is longer/ later multiplied by money required for first year of retirement.....for this

• Money here is simple cash assets or equivalent ...
• no land/ sites...considered
• if a building, rental value is considered....
• self occupied house is not considered..

4. How much I need to invest every month to achieve retirement goal?

“Indians are great savers” sorry “Indians were great savers”. 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. Other rule says if you are in early 30s Save 10% for basics, 15% for comfort, 20% to escape. If you are late by decade add 5% more in each category.

Insurance rules of thumb

5. How much insurance should I have?

Here insurance means insurance. Rule says one should have 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 early 30s insurance should be 12-15 times of your annual income; if you are in 50s take 6-8 times.

Loan/liability/home rules of thumb

6. How big should be my House?

The value of house should be equal to 2-3 times of your family annual income. So if you & your spouse are earning total Rs 20 lakh – you should buy a house in Range of Rs 40-60 Lakh. But never exceed 60 month salary.

7. Maximum EMI that I can have?

Ideally 0 will be the best answer but few of the big assets like home 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.

8. Rules of thumb for buying a car

This is one of the biggest purchases after your home. And this is 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 & loose 6. (repeat the cycle) There are few rules that you can follow:

• Value of car should not be more than 50% of the Net annual income of the owner.
• Purchase a used car or buy a new & use it for 10 years.
• While buying car with 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% you money will double in 6 years (72/12=6) & what about if 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 rule of 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 – rule of 70 will tell you in how many years value of money will be half. You just need to divide 70 with rate of inflation so if 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.

11. Wealthy:

consider yourself wealthy? A rule-of-thumb formula used by Thomas J Stanley & William D Danko in The Millionaire Next Door, a book that studies selfmade American millionaires, can help determine if you are.

(Age *Pre-tax income)/10 == Net worth

The logic behind the formula is that the older you are and the more money you make, the more net worth you should have. Dividing by 10 is a rule-of-thumb that fits current culture. So if you are a 35-yearold living with an annual income of Rs. 6,00,000 a year, your net worth should be Rs. 2.1 million [(35 X 6,00,000)/10 = 21,00,000] for you to be considered wealthy. If you are 20 years old and you make Rs. 3,00,000 lakh a year, you would be wealthy if your net worth was greater than Rs. 6,00,000.

Some time Rules of thumb will give you false sense of security or wrong guidance – so take them with pinch of salt.