TOP 10 THUMB RULES OF INVESTMENT

 

Introduction


Every investor looks for a short-cut in the process of making profits while avoiding risks. Well, though we have to disappoint with the revelation that there are absolutely no shortcuts in the field of finance and investments without inviting significant risks, we do realize the need for an investor to have at least some kind of “support wheels” to kick off their roller coaster ride into the world of finance. Such support systems provide an opportunity for the investors to make investment decisions while saving their time and efforts on the analysis of certain aspects of their decisions.

These particular aspects of a decision something that can be easily governed and sorted out by a set of Rules of Thumbs, without the need of too much caution by the investor. Yes, a set of Rules of Thumbs is what serves as a support system (you might choose to call it an ethical hack) for investors looking for a way to save and grow their extra funds in hand.

By definition given by Investopedia, “A general rule of thumb is a guideline that provides simplified advice regarding a particular subject. It is a general principle that gives practical instructions for accomplishing or approaching a certain task. Typically, rules of thumb develop as a result of practice and experience rather than from scientific research or theory” Financial Rules of Thumbs can be thought of as general guidelines designed to help the investors with their retirement, investment, and saving needs.

A set of such few best-known Rules of Thumbs have been taken up in this article, as mentioned and discussed below.

 

Top 10 Thumb Rules of Investment

 

Note: Although a rule of thumb may be appropriate for a wide audience, it may not apply universally to every individual and unique set of circumstances.

 

Top 10 Thumb Rules of Investment

Concept:

This is by far, one of the most accurate and the most popular Rules of Thumb. As per this rule, an investor can easily figure out that in how much time his or her money will double in an investment, given the interest rate, or the expected rate of return on the investment.

How?

Divide 72 by the annual interest rate (or the expected annual rate of return) at which you are compounding your money, and you will arrive at the number of years it will take to double in value.

Points to note:

The measurement of time will be in the units of year if the investor uses an annual interest rate, in the units of months if he or she uses a monthly interest rate, in the units of weeks if a weekly interest rate is used, and so on

Example:
Mrs. Jain wants to know the length of a period within which her investments would double, if she starts investing from today, earning an annual return at the rate of 8%.

Solution: (72/8 =) 9 years

Concept:

This rule is nothing but a little variation of the previous Rule of Thumb. As per this rule, an investor can easily figure out that in how much time his or her money will triple in an investment, given the interest rate, or the expected rate of return of the investment.

How?

Divide 114 by the annual interest rate (or the expected annual rate of return) at which you are compounding your money, and you will arrive at the number of years it will take to triple in value.

Points to note:

The measurement of time will be in the units of year if the investor uses an annual interest rate, in the units of months if he or she uses a monthly interest rate, in the units of weeks if a weekly interest rate is used, and so on

Example:
Mrs. Jain wants to know the length of a period within which her investments would double, if she starts investing from today, earning an annual return at the rate of 8%.

Solution: (114/8 =) 14.3 years (approx.)

Concept:

Again, this rule is a little variation of the previous two Rules of Thumb that we have read so far. As per this rule, an investor can easily figure out that in how much time his or her money will quadruple in an investment, given the interest rate, or the expected rate of return on the investment.

How?

Divide 114 by the annual interest rate (or the expected annual rate of return) at which you are compounding your money, and you will arrive at the number of years it will take to quadruple in value.

Points to note:

The measurement of time will be in the units of the year if the investor uses an annual interest rate, in the units of months if he or she uses a monthly interest rate, in the units of weeks if a weekly interest rate is used, and so on.

Example: Mrs. Jain wants to know the length of a period within which her investments would quadruple, if she starts investing from today, earning an annual return at the rate of 8%.

Solution: (144/8 =) 18 years

 

Concept:

An economy is always subject to at least some rate of inflation (or deflation, but here we assume deflation doesn‟t take place at all). An investor‟s buying power reduces as inflation comes into the picture of economy. In other words, inflation reduces the value of an investor‟s wealth. This particular Rule of Thumb, thus, becomes very useful as with its help, an investor can calculate how fast the value of his or her investments will be reduced to half of its current value.

How?

Divide 70 by the annual inflation rate and you will arrive at the number of years it will take for the value of your wealth to half.

Points to note:

  • The measurement of time will be in the units of a year if the investor uses an annual inflation rate, in the units of months if he or she uses a monthly inflation rate, in the units of weeks if a weekly inflation rate is used, and so on.
  • This rule assumes that inflation rate remains constant throughout the period, which is often not the case in reality. Hence, this rule would provide an approximate solution.

Example: Mrs. Jain wants to know the length of a period within which the value of her investments would reduce to half of its current amount. The approx. inflation rate present in the economy is 5%.

Solution: (70/5 =) 14 years

 

Concept:

This rule states that you can on an average expected annual rate of returns of 10% on equities, 5% on bonds and 3% on liquid cash and cash-equivalent accounts in the long run. It‟s important to remember this rule before reaching for that extra half percent that might lead to a capital loss.

Points to note:

  • This rule takes the long-term averages into consideration.
  • This rule derives its value from the statistical methods applied to the historical returns of investment classes. An investor must aware of the fact that past performance of an asset might not repeat itself in the future.

Example: Mrs. Jain has the following portfolio; Rs. 50,000 invested in Equity Shares, Rs. 30,000 in Bonds, and the rest Rs. 10,000 in Liquid Funds. She wants to know the average value of her portfolio after 30 years.

Solution: Using the Rule of 10:5:3, we know that Mrs. Jain would earn an annual average return of 10% on equity, 5% on bonds and 3% on simple cash-equivalents. Therefore, after 30 years, the value of her investments will be (872470 + 129658 + 24272 =) Rs. 1026400 (approx.)

Concept:

While emergencies can‟t always be avoided, having emergency savings can take some of the financial stings out of dealing with these unexpected events. An emergency fund is a separate saving or bank account used to cover or offset the expense of an unforeseen situation. It shouldn‟t be considered a nest egg or calculated as part of a long-term savings plan for college tuition, a new car, or a vacation. Instead, this fund serves as a safety net, only to be tapped when financial crises occur.

While the size of your emergency fund will vary depending on your lifestyle, monthly costs, income, and dependents, the Rule of Thumb is to put away at least 3 to 6 months‟ worth of expenses. You may also want to consider adjusting the amount based on your bill obligations, family needs, job stability, or other factors.

Points to note:

  • Emergency savings should be placed in relatively stable accounts that can be accessed easily without taxes or penalties.
  • Emergency savings are best placed in an interest-earning bank account, such as a money market or interest-earning savings account OR an investor can also invest his/her funds in a high-rated Liquid Fund.

 

Concept:

A Rule of Thumb formula used by Thomas J Stanley & William D Danko in „The Millionaire Next Door‟, a book that studies self-made American millionaires, can help determine if an investor is one. The logic behind the formula is that the older an investor is and the more money he or she makes, the more net worth he or she should have.

How?

(Age x Pre-tax Income) /10 = Net Worth

Points to note:

  • Dividing by 10 is a rule-of-thumb that fits American conditions.
  • Indian financial experts argue that a divisor that‟s closer to 20 would be more realistic in the Indian economy.

Example: Mrs. Jain is 30 years old Indian citizen with an annual salary of Rs. 20 lakh. As per the Rule of Net Worth, her wealth as of now should be [(30 x 20,00,000)/20 =] Rs. 30,00,000.If Mrs. Jain‟s actual net worth is Rs. 30 lakh, or above, she should consider herself as wealthy. If below, then not.

 

Concept:

This is a rule of thumb developed over the years in the attempt to provide guidance for equity and debt allocation decisions. As per this rule, one should take 100 and subtract the current age; the resulting number is the percentage that must be allocated to equities and remaining to the debt asset class. As the age increases the allocation to equities keeps declining, reducing volatility and risk of the portfolio.

Points to note:

  • The issue with this rule is it is not aligned with the financial goals which are the actual purpose of creating a financial portfolio and building a corpus.
  • This rule might be a good starting point. However, various factors like life expectancy, the age of retirement, financial goals and even the risk profile of the investor should be considered before making the asset allocation decision.

 

Example: Mrs. Jain, a woman of age 30 wants to allocate Rs. 1 lakh to her investment venture. She understands the need to diversify her investments but she is not sure how where and how to allocate that corpus of funds, i.e. in what asset classes and in what proportion.

Solution: Mrs. Jain can make the use of Rule of {100-Age} to figure out at least this that how much proportion of her funds she should be putting in the basket of equity.
Using the rule tells her that approximately (100-30 =) 70% of her total funds need to be under Equity Investments.

Concept:

Also known as “Pay yourself first Rule”, this Thumb of Rule states that right from the first salary, an investor must put away at least 10% of his or her income into his or her Retirement Fund. However, it is heavily recommended to increase these periodic saving amounts for the Fund as the income of the investor increases.

How?

  • Before you pay your bills before you buy groceries before you do anything else, set aside a portion of your income to save. Put the money into your Retirement Fund. The first bill you pay each month should be to yourself.
  • Choose a Fund with a high rate of return— usually, these types of funds limit how often you can withdraw money, which is a good thing because you’re not going to be pulling money out of it, anyway.

 

Concept:

The four percent rule is a rule of thumb used to determine the number of funds to withdraw annually from a Retirement Account each year. This rule seeks to provide a steady stream of funds to the retiree, while also keeping an account balance that allows funds to be withdrawn for a number of years. The 4% rate is considered a “safe” rate, with the withdrawals consisting primarily of interest and dividends. While some retirees who adhere to the four percent rule keep their withdrawal rate constant, the rule allows it to be increased to keep pace with inflation.

Points to note:

The guideline says you should withdraw 4 percent during your first year of retirement, and continue withdrawing the same amount, adjusted for inflation, each year after that.

Example: Mrs. Jain retires with Rs. 7,00,000 in her portfolio.
Following the Rule of Thumb, in the first year of her retirement, she would withdraw 4% of her entire retirement corpus, i.e. Rs. 28,000 (7,00,000 x 0.04 equals 28,000).

The following year she would withdraw the same amount, adjusted for inflation. Assuming 3% inflation, she should withdraw Rs. 28,840 (28,000 x 1.03 equals 28,840).



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