“It is better to be approximately right than precisely wrong” ~Warren Buffet
How much money should I save for my retirement to maintain my current lifestyle?
How much money can I withdraw every year from my retirement corpus without ever running out of funds? What percentage of returns do I need to target for my investment to triple in 10 years? What is the maximum amount I can spend on a new car? How much should I be investing in equities for my age?
Do you need quick answers which are approximately correct and are based on practical experience, wisdom and common sense? Enter “Thumb rules”…..
The early use of the phrase “thumb rule” has been traced back to the 16th century. While the precise origin is not clear, the most convincing theory is that the thumb was used in those days for approximate measurements.
Ex: It was used for judging the distance between two objects on a table or for checking the alignment between two things (by holding the thumb in the eye line).
From a not so precise origin, the number of thumb rules has really flourished. Now we have thumb rules for virtually every sphere of human activity. The world of finance and investing is no exception with tons of thumb rules available, some useful and some not so useful.
My interest in thumb rules was piqued due to a fine twitter conversation I had on the “millionaire next door” net worth thumb rule. This post is the result of that conversation which led me to explore the other popular and useful financial thumb rules.
Rules for the Road
Before we get started on the list of financial thumb rules, a few points:
1. Thumb rules are not set in stone to give you precise answers.
2. Many thumb rules have their origins on practical wisdom. Do not expect scientifically proven research data to back it up.
3. Take all thumb rules with a pinch of salt. You can decide if the pinch needs to be increased to a handful in your specific scenario.
4. There are many subtle and some not so subtle variations of the popular thumb rules. Each wise head adding a twist like a chef giving his personal touch on a popular dish. Choose wisely the variation you intend to use.
5. Sometimes sound advice and commonsense are presented as thumb rules. Advises not involving any form of numerical calculation is NOT the focus of this post.
Now, we are good to go.
Financial and Investing Thumb Rules
Rule #1: Expected Net worth Rule (Millionaire Next Door formula)
This rule is used to arrive at your expected net worth based on your income and age. It was published by Thomas Stanley and gained popularity with the book “The Millionaire Next door”.
Rule: 10% X Age X Gross Annual Income (Pre-tax) = Expected Net worth
For a 40-year-old with an annual income of INR 25,00,000,
Expected Net worth = 10% X 40 X 25,00,000 = 100,00,000 ( 1 crore or 10 million)
As with every thumb rule, there are some limitations. For e.g. applicability for young people starting their career.
Rule #2: 4% Safe Withdrawal Rule
This rule was published originally in 1994 by William Bengen where he proposed a safe withdrawal rate from the retirement corpus.
Rule: The rule states that you may withdraw 4% of your retirement corpus in the initial year of retirement and from the next year onwards adjust your withdrawal amount for inflation and yet you will never run the amount of money.
Let us say the retirement corpus is INR 100,00,000 ( 1 crore or 10 million) and inflation is at 5% for the first 3 years.
Year1: Safe Withdrawal Amount = (100,00,000) x 4% = 4,00,000.
Year 2: Safe withdrawal amount = (4,00,000) X (1.05) = 4,20,000
Year 3: Safe withdrawal amount = (4,20,000) X (1.05) = 4,41,000 and so on…………
Rule #3: Retirement Corpus Rule
This is another rule which talks of the retirement corpus amount you need to accumulate before calling it quits having a peaceful and financially stress-free retirement life.
Rule: Retirement corpus = 20 X Gross Annual Income
Let us say your annual income is 25 lacs ( 25,00,000) then your retirement corpus should at least be 5 crores ( 25 lacs X 20) to maintain your current lifestyle.
There are variations of this rule where financial planners’ advice up to 30X of annual income considering the increasing life expectancy and inflation.
As Mae West said, “Too much of a good thing can be wonderful”. Aim to accumulate at least 20X. If you can do anything more, then it’s wonderful.
Rule #4: 100 Minus Age Rule
This thumb rule tells an investor what portion of his portfolio should be in equities. The logic is that as an investor gets older, their risk-taking appetite reduces and hence would not prefer large swings in portfolio value.
This rule was made even more popular when John Bogle said, “My favorite rule of thumb is (roughly) to hold a bond position equal to your age – 20 percent when you are 20, 70 percent when you’re 70, and so on – or maybe even your age minus 10 percent.”
Rule: Percentage of the portfolio in equities = (100 – your age)
If you are 40 years old then the suggested percentage of allocation to equities would be 60% (100 – 40). An alternate way to put this is that the percentage of allocation to bonds would be 40% (equals your age). As with every thumb rule, there are different versions out there with some experts substituting 100 with 110 or even up to 140. For all practical purposes, an investor can stick with the original rule of 100.
Rule #5: Rule of 72
This thumb rule is used to estimate the number of years it would take to double your investment given your expected rate of return.
Rule: No. of years to double = 72 / rate of return
Example: With the current fixed deposit rates in Indian banks for long term deposits hovering around 6%, it would take approximately 12 years to double your money (72 / 6)
Rule #6: 20% Down Payment Rule
This thumb rule basically applies to the minimum down payment a borrower should pay from his own funds while taking any form of loan liability (Housing loan / Car loan / any other loan).
The rationale for the rule is twofold. First and foremost the 20% down payment is a barometer to infer whether the borrower is stretching beyond means or well within his affordable limits. Secondly, the higher the down payment, the lower will be the interest liability for the borrower.
If a posh villa cost 1 crore (10 million) then the prospective buyer taking a housing loan should at least pay 20,00,000 (20% of 1 crore) as margin / own contribution. In case the buyer is finding it difficult to put the 20% share then in all probabilities, the buyer is stretching beyond prudent levels.
Rule #7: 36% Debt Rule
Assuming you are a wonderful customer for your bank having availed housing loan, vehicle loan and personal loan then this rule states the maximum amount you can spend by way of loan/debt payments.
Rule: Maximum Monthly debt (EMI) payments = 36% of gross monthly income
Example: If you make 1 lac (1,00,000) a month then the total of all your monthly loan EMI’s should not exceed 36,000.
Rule #8: Emergency Fund Rule
This rule talks of the amount a person needs to set aside in a liquid asset (cash, savings account, short term fixed deposit) to face any emergencies like loss of employment, illness, business downturn, etc.
Rule: Emergency Fund = 6 X Monthly household expenses*
*Household expenses also include the monthly loan EMI payments
Example: Let us say your monthly commitments and expenses add up to 50,000 then your emergency fund should be ideally 300,000 (3 lacs). There are variations ranging from 3X for people starting their careers to 10X for the conservatives. Take your pick.
Rule #9: 1% Windfall Rule
This is a very important rule worth remembering. This talks of what needs to be done in case you hit a jackpot say, lottery/inheritance/house sale/multi-bagger stock picks. This rule prevents you from taking impulse decisions like splurging on a new car or house and thereby losing the fortune.
Rule: In case of a windfall take out 1% of the proceeds after taxes and treat yourself. The rest of the money to be set aside in a bank account to be left untouched for at least 6 months. Some studies have shown that 50% of the windfall is lost in a relatively short period of time and also that 70% of the fortune won through the lottery is lost within 3 years. So this rule becomes crucial to preserve the windfall from rapidly eroding.
Example: If you get an inheritance of 1 crore (10 million) then spend 1% or 1,00,000 on yourself and your family. The remaining 99,00,000 to be set aside in bank account for 6 months.
Cover Image Source: Student Loan Hero