I had written this post in February 2012. However, given a lot of reader emails on topics covered herein, I am re-posting it.
Lately I’ve found myself using several rules of thumb when it comes to how I manage my personal finances.
A rule of thumb, while not meant to be completely accurate, is an easy way to approximate a value quickly.
Here are some rules of thumb that I practice for managing my own personal finances. I hope you will find some of these useful for your own purpose.
1. Rule of 72. The Rule of 72 states that you can divide the number 72 by whatever yield you are getting 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).
2. The number one rule of saving money is: Pay yourself first. It’s very important to set aside your savings every month before you use the money for other things, including paying of bills. Always pay yourself before anything else.
The standard rule of thumb is to save at least 10% of your income. In this period of consistently high inflation, I believe a better goal is to aim for 20%.
Also, if you’re young, you can follow this rule of thumb – Save 10% of your income for your basic needs, 15% for comfort, and 20% to escape wherever you want.
3. When you’re saving money for retirement, the standard advice is save about 20x your gross annual income to retire. In other words, if you earn Rs 10 lac per year, you’ll need Rs 2 crore to retire. I think this rule won’t work in today’s environment because it focuses on income and not expenses (which are rising faster than the former).
I recommend a different rule of thumb: Base your retirement needs on 30x your current annual expenses. This assumes that you will live for 30 years post retirement. Of course, looking at the average Indian’s life expectancy of around 65 years, you may live lesser than 30 years post-retirement. But those additional years of savings will take care of the inflation that will see your annual expenses rise over the years.
4. I found this on the Internet, and thought it was as useful as it was clever. Your emergency fund should cover X months of expenses, where X is the current unemployment rate.
In other words, because India’s unemployment is at around 10% right now, you should aim to have enough money in the bank to cover ten months of expenses. The general rule of thumb anyways calls for a range of 6-10 months of expenses.
5. Know your risk tolerance ‘before’ you begin investing. The time to decide how much you can afford to lose in the stock market is before a crash, not after one.
6. The widely regarded asset allocation rule of thumb is to have X% of your portfolio invested in stocks, where X is equal to 100 minus your age — with the rest invested in lower-risk investments like bonds. I believe this is an incorrect way to look at things.
A better way to look at asset allocation is to first answer this question – “Am I a stock or a bond?”
The answer lies in understanding yourself – your life, and your career.
You are a bond if you have a stable job that is unaffected by the volatility of the stock markets, and you have many years left to work.
On the other hand, you are a stock if you have little years of work ahead of you, or if you work in a volatile and unpredictable field that could decline quickly with little notice (like the stock markets itself!).
So if you are a ‘bond’, have a larger part (say around 60-70%) of your portfolio in stocks to balance it out. And if you are a ‘stock’, tilt your portfolio in favour of bonds (or similar instruments).
7. Save for your own retirement before saving money for your children’s college education. They can get education loans. You can’t get retirement loans!
8. In general, save an emergency fund first; pay off high-interest debt second; and begin investing last.
9. If you’re not willing to pay cash for it, then it doesn’t make sense to buy it on credit.
10. If you get a windfall, use 1-2% to treat yourself. Put the rest in a safe place that will earn you interest and ignore it for six months. Allow the initial emotion to pass. Get over the initial urge to spend the money on a big house or a bigger car. Live your life as you had before. After you’ve had time to think about it, make your decisions.