5 Financial Thumb rules you must know

thumbnail
Reading Time: 4 minutes



Issue no. 004 , July 26, 2020

“It is better to be approximately right than precisely wrong”  Warren Buffet

Every investor would have had one or more of these questions in their mind at some point of their life:

  • How much money should I save for my retirement to maintain my current lifestyle?

  • How much money do i need to achieve financial freedom ?

  • How much money can I withdraw every year from my retirement corpus without ever running out of funds?

  • How much should I be investing in equities at my age?

  • I have an offer for doubling my money in “X years. Should i take the offer ?

Do you need approximately right answers ? Knowing these 5 thumb rules helps…

Rule No.1: Expected Net worth Rule

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

Example

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.

[Additional Reading:  How wealthy you should be by Thomas Stanley]

Rule No 2: Bengen rule ( 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 amount of money.

Also Read on FinMedium:  Bajaj Consumer Products 2020 Annual Report Takeaways!

Example

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.
Year 1: 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…………

This rule can be reverse engineered to find out the retirement corpus you need to have if you know your expected annual expenses.

Rule

Estimated Annual expenses  X 25 =  Retirement Corpus

Example

Let us say your estimated annual expenses is 3,00,000 ( 25,000 per month X 12) . Then you are good to retire if you corpus is 75,00,000. ( 3,00,000 X 25)
Initially the rule was proposed with a 30 year retirement life in mind. Subsequently, tons of research have found this rule to be good for any time frame.

[Additional Reading: Check out this excellent post on Bengen rule for the underlying research data]

Rule No. 3: Retirement Corpus rule

This is another rule which talks of the retirement corpus amount you need to accumulate before calling it quits to have a peaceful and financially stress free retirement life.

Rule

Retirement corpus = 20 X Gross Annual Income

Example

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 30 X 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 20 X. If you can do anything more, then it’s wonderful.

Also Read on FinMedium:  #3 Why did Gillette take a $8B cut?

Rule No 4. 100 minus age rule (or Bond equals age rule)

This thumb rule tell 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 portfolio in equities =  (100 – your age)

Example

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 No 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).

We can check the actual calculation using a compound interest calculator . If 100 is invested for 12 years at 6% then we get the future value as 201.22. (Remember the rules of the road, we are looking at being approximate right)

Also Read on FinMedium:  ITC Company and Its Peers Comparison

This rule can also be used for reverse calculating the rate of interest applicable for doubling your money for a period.

Example

Someone approaches you with an offer to double your money in 6 years. To evaluate the offer you wish to find the rate of return promised.
Return % = 72 / 6 years = 12%.
Using a CAGR calculator to cross check the calculation we get the value as 12.25%. (Again, we are approximately right)

We must be aware of one crucial thing about the rule of 72 . It does not take into account the effect of inflation / purchasing power in the calculations.

Bonus 1 : Rule of 114

Similar to the rule of 72, this rule is used to estimate the number of years it would take to triple your amount given the expected rate of return.

Rule

No. of years to triple = 114 / rate of return

Bonus 2 : Rule of 144

Similar to the rule of 72, this rule is used to estimate the number of years it would take to quadruple (4 times) the amount given the expected rate of return

Rule

No. of years to quadraple = 144 / rate of return

Here is a 15 minute presentation on the same topic

Keep reading, Happy Investing !!!

If you like what you read do subscribe



Source link

Every Wednesday and Saturday, we send Info-Graphic and FinMedium Weekly Digest newsletters to our 25000+ Subscribers.

Join Them Now!

Please Share :)
Ravi Chand
Ravichand's web home, Stock and Ladder, is devoted to the study of his life’s passion – Investing and Stock markets.
Back To Top