The 9 Thumb Rules To Achieving the Epitome of Financial Wellbeing
Nov 10, 2015

Author: PersonalFN Content & Research Team

Sometimes the best advice in life is the simplest. Michael Finke, an associate professor of Personal Financial Planning at Texas Tech University said, "Rules of thumb are generally useful for most households, because we found through our research that simplicity is good, (and) that complexity is really the enemy of good household financial decision-making."

Unfortunately, in this complicated world we live in today, vital thumb rules are perhaps forgotten or ignored.

Thumb rules are a good starting point for all those who can't or won't make time for complete in-depth financial planning. These not only save you a lot of time (as they are easy to understand and simple to practice) but naturally save you some money too. While these are useful as basic guidelines for day-to-day financial decision-making on saving and investment planning, use these cautiously.

For the busy bees, here are nine thumb rules that give you afair view of how you could structure your personal finances.

1) How much equity should I have? OR What should my asset allocation be?

This is one of the most common questions asked while investing and the answer, a common thumb ruleto it is: '100 – your age'.In other words, the proportion of debt should be equal to your age. So by this rule, asset allocation for various age groups would be as under:

The proportion to equity and debt
Age Proportion of equity
in the portfolio
Proportion of debt
in the portfolio
30 70 30
40 60 40
50 50 50
60 40 60
70 30 70
Note: Only equity oriented NFOs are considered
This table is for illustration purpose only
(Source: PersonalFN Research)

"This rule of thumb helps investors keep in mind that their portfolios need to change as they age, becoming more focused on avoiding risk in their investing than on higher growth."- John C. Bogle, Founder, Vanguard Group. The rationale behind this rule is: the older you get, less time you have to recover if the stock market tumbles and your risk appetite recedes as well. As you enter retirement, taking all your money out of equities could slow down the growth of your portfolio too much, preventing you from keeping pace with inflation and possibly deplete your retirement savings.

Although this isn't the optimal approach to structure one's asset allocation, it could be a good starting point for beginners in the investment arena.

2) How much emergency fund should I hold?

An essential component of a solid financial plan is its emergency fund (also called a contingency fund). Emergencies (such as loss of income, medical emergency, loss of assets, etc.) are contingent in nature and therefore,an astute approach would be to put away a portion of one's savings to counter these emergencies when they arise.

At PersonalFN, we believe you should hold monthly living expenses of a minimum of 6 months in a contingency fund – that includes everything from monthly household expenses, to EMI payments, orany other expenses you may incur during the course of a regular month. On the higher side, 24 months of monthly expenses can be maintained by those who area verse to risk and require high amounts of liquidity. But on an average, 12 months of living expenses can be held as contingency fund.

3) The value of the house that I can afford

The value of the house you purchase can be as high as 2 to 3 times your annual income, but no higher. This rule reminds consumers that one's income should be a primary criterion when deciding how much to pay for a house. So, if your annual income is say Rs 20 lakh, you could buy a house in the price range of Rs 40 to 60 lakh.

However, one of the demerits of this rule is that it doesn't take into account how housing costs can fluctuate based on interest rates, for those of you who opt for a home loan to buy one. For instance, a house that costs 2 to 3 times your income may be unaffordable in anelevated-interest rate scenario, but easy to pull off in a low-rate scenario.

A better decision-making tool to buying a new home is the rental prices in your area. If you could rent a home that meets your needs for less than it would cost to buy and maintain a home, then renting could be a better option than buying a house.

4) What is the maximum EMI I can service?

The best answer to this question would be 'zero'; however, the reality is big assets like buying a house cannot be purchased without either depleting all your savings or signing up for a loan. Typically, when applying for a home loan, a lender will limit your loan to an EMI that can be serviced by not more than approximately 1/3rd of your monthly income. So, if you are earning Rs 90,000 a month, the lending bank will give you a loan amount wherein your EMIs won't exceed Rs 30,000.

Hence, an EMI towards one's home loan should not be more than 30% of your gross monthly income. Your total cash outflows towards all your EMIs put together should not be more than 36% of your gross monthly income. Following this thumb rule eases the strainon your finances, which can make servicing the debt a challenge. Simply known as your debt-to-income ratio, this is as illustrated below:

Stretch within your means
Client name Total monthly EMIs
(Rs) (a)
Total monthly fixed
income (Rs) (b)
Debt to
income ratio
(c) = (a/b) x 100
A 30,000 100,000 30
B 45,000 100,000 45
C 50,000 100,000 50
This table is for illustration purpose only
(Source: PersonalFN Research)

5) How much money should I save towards retirement?

By nature, Indians are 'savers'. The number one rule of saving money is 'pay yourself first'. It is a prudent practice to set aside a percentage of one's income towards savings before using the money for other things, including paying bills. The thumb rule is to save at least 10% of your income, set it towards your retirement.

However, considering the rising cost of living, this isn't going to be enough. Take a look at the corpus built over a period of time based on the proportion saved...

More you save, the better it is!
Mr A Mr B Mr C
Monthly Income (Rs) 30,000 50,000 100,000
Percentage Saved 75% 35% 10%
Amount saved per month (Rs) 22,500 17,500 10,000
Rate of return 10% 10% 10%
Years to retirement 30 30 30
Retirement Corpus (Rs) 51,284,820 39,888,193 22,793,253
Note: Only equity oriented NFOs are considered
This table is for illustration purpose only
(Source: PersonalFN Research)

Although, Mr A was only earning Rs 30,000 per month, he was able to accumulate a higher retirement corpus than Mr B & Mr C because he saved 75% of his monthly income. To start off, make a point to save at least 20% of your monthly take-home (net) income. In due course of time, you can continue increasing the amount you save.

At PersonalFN we believe your retirement is as important a goal as planning for your children's future needs. In a world where we've witnessed the evolution of nuclear families, banking on your children for your retirement needs might be myopic. Hence, the better you plan andmore you save for your retirement, the better will your money compound when you need it.

6) How much should I withdraw from the retirement corpus?

Ideally one's withdrawal from one's retirement corpus should be as low as possible. William P. Bengen, a retired financial adviserfrom the United States of America, who's know known for the "Bengen rule" first articulated the 4% withdrawal rate ("Four percent rule") in 1994 as a thumb rule for withdrawal rates from retirement corpus. Mr Bengen found that retirees who draw down no more than 4% of their portfolio in the initial year, and adjust that amount subsequent every year for inflation, stood a great chance that their money would outlive them.

This simple formula has proven accurate over time, helping people easily figure out a guideline for how much they should withdraw so as not to exhaust their retirement savings.

However, much has changed in today's investment environment. With the plethora of complex investment products, combined with longer life spans, and changes in taxation laws, means that your retirement money needs to last longer.

Considering your retirement corpus may have to last more than 30 retired years, the odds of success are highly dependent on your annual withdrawal rate.

Essentially, the earlier you start tapping your retirement savings, the lower the annual withdrawal percentage must be for savings to last.

For example, if you'll retire at age 60, it's probably smart to withdraw 2 or 3% of your nest egg. Retiring at age 70, by contrast, may let you pull out 6 or 7% of your money each year.

However, at PersonalFN we believe that one's personal withdrawal rate would depend a lot on the time horizon, asset allocation, one's lifestyle, and the investment returns. It is advisable to consult a financial planner who can help assess your situation and work with you to ensure that your money lasts as long as you do, by building a comfortable cash flow to meet your retirement needs.

7) Pay off that Credit Card Debt!

It's a no brainer, retiring the highest-interest credit card debt first, regardless of size, helps consumers minimize the amount of interest they pay over time.

At PersonalFN, we believe inrepaying the outstanding dues in full every time your credit card bill arrives and always spend within means. Don't just honour the minimum payment highlighted in your credit card statement, instead pay the entire sum, or to the most extent possible. Paying the minimum amount would only ensure that a penalty isn't levied, but this won't save you from the burgeoning interest cost. The moment you carry forward your payment to the next monthly cycle, you will be liable to pay interest on the unpaid amount along with taxes, turning out to be quite expensive.

8) How much insurance should I have?

According to the 'Income Rule' used by insurance advisors, one should have a sum assured of 8 to 10 times of one's annual income. This thumb rule gives a good starting point for a bread-winner to know the amount one should be insured for in case of any unfortunate event.

However, it is a prudent practice to consult a financial planner to calculate the amount of insurance required based on the "Human Life Value" principle, which takes into account the financial goals and the outstanding liabilities while calculating the amount of insurance required.

9) How many years will it take to double my investment?

Have you ever come across an investment advisor/relationship manager insisting that you buy a certain product because it would double your money in 10 years? The next time you do come across this offer, ask him the rationale, and pay attention to the rate of return or interest rate you would earn from such an investment instrument.

The Rule of 72 states that you can divide the number 72 by whatever yield or interest to see how long it would take for your investment to double. For instance, if your fixed deposit earns an annual interest of 8%, it will take 9 years for your money to double (72/8).

Using thumb rules gives us a basic understanding of how to structure your finances. Caution states, it is a possibility for you gain a false sense of security, so it is advisable to take these with a pinch of salt too. Although, thumb rules are a good starting point, it is advisable to consult a financial planner to achieve one's financial goals.

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