17 popular financial thumb rules

17 popular financial thumb rules to remember

“It is better to be approximately right than precisely wrong”  Warren Buffet
How much money should I save for my retirement to maintain my current lifestyle? How much money can I withdraw every year from my retirement corpus without ever running out of funds? What percentage of  returns I need to target for my investment to triple in 10 years? What is the maximum amount I can spend on a new car? How much should I be investing in equities for my age?
Do you need quick answers which are approximately correct and are based on practical experience, wisdom and common sense ?  Enter “Thumb rules”…..

The early use of the phrase “thumb rule” has been traced back to the 16th century. While the precise origin is not clear, the most convincing theory is that the thumb was used in those days for approximate measurements. E.g. it was used for judging the distance between two objects on a table or for checking the alignment between two things (by holding the thumb in the eye line).
From a not so precise origin, the number of thumb rules have really flourished. Now we have thumb rules for virtually every sphere of human activity. The world of finance and investing is no exception with tons of thumb rules available, some useful and some not so useful.
My interest in thumb rules was piqued due to a fine twitter conversation I had on the “millionaire next door” net worth thumb rule. This post is the result of that conversation which led me to explore the other popular and useful financial thumb rules.

Rules for the road

Before we get started on the list of financial thumb rules, few points:

  • Thumb rules are not set in stone to give you precise answers.
  • Many thumb rules have their origins on practical wisdom. Do not expect scientifically proven research data to back it up.
  • Take all thumb rules with a pinch of salt. You can decide if the pinch needs to be increased to a handful in your specific scenario.
  • There are many subtle and some not so subtle variations of the popular thumb rules. Each wise head adding a twist like a chef giving his personal touch on a popular dish. Choose wisely the variation you intend to use.
  • Sometimes sound advice and commonsense are presented as thumb rules. Advises not involving any form of numerical calculation is NOT the focus of this post.

We are good to go.

Financial and investing thumb rules

 

Expected Net worth Rule (Millionaire Next door formula)

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]

4% Safe withdrawal rule (Bengen 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.

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.
Year1: 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]

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 atleast be 5 crores ( 25 lacs X 20) to maintain your current lifestyle
There are variations of this rule where financial planners’ advice up to 30X 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 20X. If you can do anything more, then it’s wonderful.

100 minus age rule (or Bond portion 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 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)
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.

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

Example

Using the same data as rule of 72, No. of years to triple would be 114 / 6 = 19 years.

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

Example

Using the same data as rule of 72, No. of years to triple would be 144 / 6 = 24 years.

20% down payment rule

This thumb rule basically applies to the minimum down payment a borrower should pay from own funds while taking any form of loan liability (Housing loan / Car loan / any other loan).
The rationale for the rule is twofold.  First and foremost the 20% down payment is barometer to infer whether the borrower is stretching beyond means or well within his affordable limits. Secondly, higher the down payment, lower will be the interest liability for the borrower.

Example

If a posh villa cost 1 crore (10 million) then the prospective buyer taking a housing loan should at least pay 20,00,000 (20% of 1 crore) as margin /  own contribution. In case the buyer is finding it difficult to put the 20% share then in all probabilities the buyer is stretching beyond prudent levels.
thumb rules on house

House Affordability rule

This thumb rule helps the home buyer decide on the maximum amount they can spend on buying a house or property. It would be wise to keep the purchase price of the house within this amount.

Rule

Maximum value of house = 2.5 X Annual Income.

Example

Let us say the annual income is 30 lacs (30,00,000). The maximum value of the house should be less than 75 lacs (30 lacs X 2.5)
There are variations of this rule where the suggested range varies between 2X to 3X of the Annual income. Still we get a fair picture of the possible range of values (60 lacs to 90 lacs). In the event of the buyer liking a property worth say 1.5 crores (15 million) then it is obvious that the price is above the prudently acceptable affordability range.

28% Housing EMI rule

This rule talks of the maximum amount one can budget for housing loan monthly EMI payments.
Everyone loves to own a big house from a reputed builder in a posh locality. The tax rebates on housing loan payments gives further incentives to a prospective home buyer to go for bigger houses. This rules helps us with a reality check.

Rule

Maximum Monthly Home loan EMI = 28% of Gross monthly income

Example

If you make 1 lac (1,00,000) a month then your monthly home loan EMI should not exceed 28,000.
thumb rules on car

20/4/10 Vehicle rule

This rule talks about the prudent practices while purchasing a vehicle / car by way of a loan.

Rule

The rule states that you should make a down payment for the loan of at least 20% of the on road price; the tenure of the vehicle loan should not be more than 4 years; the total expenses towards the car ownership should be less than 10% of gross annual income (total expenses ideally should include vehicle loan EMI expenses + fuel expenses + insurance + any other vehicle expenses like parking rentals )

Example

Let us say your annual income is 20 lacs (20,00,000). This rule states that your yearly transportation costs (car loan EMI + annual fuel expenses + annual insurance) should be less than 2 lacs.

50% Car rule

This rule talks about the maximum price we can budget for purchase of a new car.

Rule

Car affordability = 50% of Gross annual income

Example

If you are making 20 lacs per year (gross) then you can plan for a car worth 10 lacs. In this case if you wish to go for a new Audi Q7 worth 70 lacs then clearly you are stretching beyond your affordable range.

10 year Car rule

This rule states that to be financially prudent one needs to use a new car for at least 10 years. Car is one thing which depreciates quickly. The value of a car falls minimum 15% the moment it hits the road and is out of the showroom.
10 years of vehicle ownership is considered ideal to get maximum value of your vehicle purchase taking into consideration the effects of depreciation as well as possible spiraling of maintenance expenses of older vehicles.

36% Debt rule

Assuming you are a wonderful customer for your bank having availed housing loan, vehicle loan and personal loan then this rule states the maximum amount you can spend by way of loan / debt payments

Rule

Maximum Monthly debt (EMI) payments = 36% of Gross monthly income

Example

If you make 1 lac (1,00,000) a month then the total of all your monthly loan EMI’s should not exceed 36,000.

Emergency Fund rule

This rule talks of the amount a person needs to set aside in a liquid asset (cash, savings account, short term fixed deposit) to face any emergencies like loss of employment, illness, business downturn etc.

Rule

Emergency Fund = 6 X Monthly household expenses*
*Household expenses also includes the monthly loan EMI payments

Example

Let us say your monthly commitments and expenses add upto 50,000 then your emergency fund should be ideally 300,000 (3 lacs).
There are variations ranging from 3X for people starting their career to 10X for the conservatives. Take your pick.

10% saving rule

Saving for a rainy day is a practice followed from the early days of human civilization. This rule talks of the amount we need to save to build our retirement nest egg.

Rule

Minimum monthly savings = 10% of Gross monthly income.
Saving 10,000 if you are making 1 lac is the minimum suggested amount. Ideally the percentage should be above 20% if you wish to have a decent corpus and a decent lifestyle. One crucial thing also is to start saving early.

48 Hour Rule

This thumb rule is useful against impulse purchases. The rule states that when you have a strong urge to make an impulse purchase then postpone the purchase for 48 hours.
If even after 48 hours the urge still remains then go ahead with the purchase. In most cases it has been found that the urge is no more there. This also prevents piling on debt / credit card dues because of impulse purchases.
[Additional reading:  How 48 hour rule can help you avoid debt]

1% Windfall rule

This is a very important rule worth remembering. This talks of what needs to be done in case you hit a jackpot say, lottery / inheritance / house sale / multi-bagger stock picks. This rule prevents you from taking impulse decisions like splurging on a new car or house and thereby losing the fortune.

Rule

In case of a windfall take out 1% of the proceeds after taxes and treat yourself. The rest of the money to be set aside in a bank account to be left untouched for at least 6 months
Some studies have shown that 50% of the windfall is lost in relatively short period of time and also that 70% of the fortune won through lottery is lost within 3 years.  So this rule becomes very crucial to preserve the windfall from rapidly eroding.
Also when the news that you have hit jackpot spreads, you will have a sudden spurt in the number of friend requests as well as visits from relatives you have not seen for years. These new characters will also most likely disappear the moment the bounty is exhausted. To

Example

If you get an inheritance of 1 crore (10 million) then spend 1% or 1,00,000 on yourself and your family. The remaining 99,00,000 to be set aside in bank account for 6 months.
[Additional reading:  How to manage a windfall successfully ]

Final Thoughts

Financial thumb rules are  based on practical experience, common sense and wisdom. The thumb rules detailed in this post are precisely that and are intended to help us with quick (approximately correct) answers.
However, while using these thumb rules, the user must also try to understand the rationale or assumptions behind each rule. Blindly following the thumb rules may be injurious to your financial health. As Buffet put it brilliantly “Too often, though, investors forget to examine the assumptions behind the models”.
Thumb rules provide a fine starting point or a reference on which you can build your final decisions.
(Images: Stocksnap.io)
Please call out in the comments if you know of any other popular (and useful) thumb rule which needs inclusion.

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