Rules of Thumb in Financial Planning

Financial Planning, Rules of Thumb

Rule of thumb is an interesting word in English which is used to refer to a means of estimation based on a rough  practical rule, which is not scientific or accurate. The origin of this phrase is still a mystery because there are different stories or tales that date back to 17th century or even earlier.

Financial planning rules of thumb are very basic but not fool proof. Everybody’s financial situation is different, but the rules of thumb for financial planning provide a broad indicator which can used to simplify your financial query.

Using Rule of Thumb

In simple language rule of thumb is a quick way to make quick rough estimates. For example, what is the average height of an adult male in India? I don’t know the exact figure, but I can guess that it should be somewhere between 5 feet 3” to 5 feet 6”. This is no rocket science. I know that a very small % of male adults are above 6 foot, and people below 5 foot also constitute a small %age, but a large population exists between 5 feet and 6 feet.

Rule of thumb is also used by researchers or marketers to estimate the market size. Sometimes people in the financial world use rules of thumb to predict the market behavior or trends. Let us see how this can be used in planning your financial health.

Rule of 72

Many people use this to gauge how long would it take for their money to double. For example if your bank offers a 9% interest p.a. on a fixed deposit how long would it take to double your money? According to rule of 72 it would take 8 years.

Time taken to double = 72/(interest rate)

OR

Interest Rate = 72/(number of years)

Similarly, lets hypothetically assume Mr.Thomas invested in a bond in US for 12 years and doubled his money. What would be the rough interest rate earned by Thomas? It would be 6% roughly.

If you are really not sure you can cross check the calculations using MS excel or an advanced calculator.

But this rule may not provide accurate results (For more information on this, see (ptmoney.com). The use of the number ‘72’ is also something to do with its divisibility – it is divisible by 2,3,4,6,8,9,12,18,24 and 36 making it easier for calculations.

Emergency Funds

This sum should be atleast 3-6 months of your expenses. This is one of the rules of thumb to give you the minimum amount of emergency funds required for a single individual with an average lifestyle. This is only a rough estimation subject of lot of debate. What if you have a wife (home maker) and two young kids? In this can probably it may be at the higher end of the range or even more.

Lets take a situation which is not quite uncommon in Indian families.

Assume Mr.Gajodhar, a bank employee in a clerical position has a family consisting of 3 children and a wife dependent on him. In addition he also has to support his old father and mother who live in the same household.

Asset Allocation towards Equity

Most financial advisors recommend that one should invest more in equity and less in debt at a younger age and gradually do the vice versa as you grow older. If you see the table below you will see how it works.

Age Equity Debt
25 75% 25%
30 70% 30%
35 65% 35%
40 60% 40%
45 55% 45%
50 50% 50%
55 45% 55%
60 40% 60%

The rules of thumb say that you must invest a % in equity which is roughly equal to [100-your age]. Or in other words your allocation to debt will be equivalent to your age.

Sounds so perfect and simple? What about gold, real estate, etc.? Should we ignore that just because it does not fit your rules of thumb? Not really, but this rule talks only about equity and debt exposure and the story ends there. Beyond this your common sense should be good enough to take care of the remainder of your investments.

But the lesson is clear that as you get older you have less time to risk your capital and build wealth. Particularly people who are in the late 50s or 60s would be keen on preserving what they built rather than investing more in equity. So for the senior citizen class equity exposure will generally not exceed 40%.

Remember that nothing is taken out of the table – every asset – equity or debt is still part of the overall pie, while the %age allocation changes. What happens is when capital gains are made (over the years) in equity these sums are gradually re-invested in debt to restore balance and stability to ones portfolio.

How Much Insurance Should I Have?

Roughly 8-10 times annual income is the required amount of insurance. However, note that this is a bare minimum which tries to calculate the lump sum required to replace your income for x years after your demise. So in a case where such unfortunate event of your demise happens your dependants will be able to have access the income stream.

Now this is only the income side of the story. What about future plans in the family like higher education plan for kids in India or abroad, wedding expenses, providing estate or lump sum to your kids, liabilities/debts you have, other goals of family members, etc.

The rule of 8-10 times income is the starting point that defines the bare minimum. This is still shown as a range because a one-size fit all approach doesn’t work.

How Much of EMI Can I Have?

As a rule of thumb I would say not exceeding 40% of your monthly income assuming this includes home loan EMIs. In an ideal scenario zero EMI would be a better option. Today its important to use some financing or debt in a moderate fashion to achieve your goals or to meet certain needs.

For instance a housing loan, educational loan or credit cards are part of life. Even personal loans, car loans, etc are good options provided they are used wisely without stretching to the last penny.

Even banks check for this aspect when they underwrite loans. For instance in case of home loans the bank would ensure that the total EMI does not exceed 50% of your monthly income.

Lets say Mr.Balachander, Manager in a mid-sized FMCG firm earns Rs.40,000 per month. When he applies for a home loan to PDFC Bank the bank say that it can sanction a loan of up to Rs.18 lakhs where the EMI comes close to Rs.20,000 for an Rs.18 lakh loan.

However, Balachander was looking for atleast Rs.25 lakh to purchase an apartment worth Rs.30 lakh in Chennai, while he can bring in Rs.5 lakhs from sale of assets and savings.

Here Balchander has three options:

  • Look for a higher loan amount from other banks
  • Increase his income (which takes time)
  • Mobilize cash from sale of assets or other personal savings (beyond Rs.5 lakhs)

His friend Manohar who also works with TBI says that the maximum loan amount will be 75% of property value in the current market. Based on this rule of thumb Balachander will get a maximum of Rs.22.5 lakhs at the most from the bank offering favorable terms. So there is still a gap of Rs.2.5 lakhs (25-22.5). The fourth alternative is to look for similar properties with a lower price tag.

The rules of thumb can be summarized as below:

Rules of Thumb Assumption Financial Soundness
EMI <= 50% of Monthly Income Assuming EMI includes home loan EMIs Good
EMI <= 40% of Monthly Income Assuming EMI includes home loan EMIs Very Good
EMI <= 30% of Monthly Income Where there is no home loan Good
EMI <= 20% of Monthly Income Where there is no home loan Very Good

Note: The only exception to these rules apply to a case where you take educational loan or where rental income

Benefit of Rules of Thumb

Simple: They are simple to estimate or understand. You don’t have to use spreadsheets or trigonometry or special formulas. In most cases you can calculate in your head. Don’t get me wrong here – you don’t have to be a prodigy or a math genius to understand these. Simple common sense is all that you need.

Quick Answers/Solutions: You can get quick answers to questions like “How many years will it take to double my money?”

Reference/Guideline: Thumb rules also provide checks and balances to see if you are going in the right direction or if you are following certain basic ground rules.

Aids Quick Comparison: This is an extension of the second point. When you have a thumb rule you can compare different options (say A, B, C, D & E) using the rule to shortlist the once which meet the set rule or criteria. Thus you don’t have to spend a lot of time and effort on evaluating or analyzing different options.

Drawbacks

Reliability: By definition thumb rules are only rough estimates, so the chances of errors can be significant or dramatic in some cases.

Making Decision: Thumb rules can only be used for a broad level of analysis (macroscopic in nature). When it comes to micro level calculations requiring decimal accuracies the rules of thumb may fail or give misleading results.

Alternate Methods: There are people who use rule of 70, which seems even more accurate then the rule of 72. Today when you have spreadsheets or MS Excel there is no need to second guess. You can use spreadsheet tools to get an approximate or accurate estimate rather than relying on rough rules of thumb.

Conclusion

Rules of thumb helps you in providing a better focus to financial planning decisions, and enables you to achieve your financial goals. However, for precise decisions it is important to do further research or approach a financial advisor for personalized guidance and advise.

Once the foundation and structure is laid using basic rules of thumb, the finer aspects can be gradually built around it and managed continuously overtime. Discipline in adhering to basic rules will put you on the path to make your first million.

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About the Author

Sridhar is a financial analyst and his work experience spans areas of financial analysis, modeling, valuation and research on companies, specific sectors, etc. Sridhar is an MBA graduate with Finance major from Maharishi Institute of Management.

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