BASIC INVESTING THUMB RULES – A SIMPLE GUIDE FOR BEGINNER INVESTORS

“Investments, saving, retirement planning, stock markets”…these words can cause a bit of anxiety among new investors, prospective investors. It’s understood that making long term financial decisions is not an easy task but, there are a bunch of Investment thumb rules that make this process a lot easier.

By following these thumb rules of basic investing a new investor can take investment decisions without getting into complex calculations or being overwhelmed by what to do and what not to do.

These thumb rules are great to start investing. But as your income and financial liabilities grow it make sense to adjust these rules to suit your financial requirements.

In this article we will discuss some of the most important investment thumb rules:

Asset allocation strategy:

Asset allocation is one of the most important factors in determining performance of a portfolio. To a great extent the end results depend on how investor has allocated the investment amount between equities, stocks, fixed income funds and other asset classes.

 

Rule of Thumb # 100 minus our age should be our minimum equity allocation i.e.

If you are 30 years old 70% of your asset allocation should be in equity.

 This is because equity has the highest potential to grow in value over a period of time. Equity returns have outperformed the returns of most other forms of investments/asset classes and in the long term created wealth for investor. Long term disciplined investing in equities tends to be less impacted by unfavorable market movements and volatility.

Equities are high risk investment with higher potential returns. High risk also indicates that the investor stands to lose some or his entire investment amount if markets move downwards hence a person reaching close to retirement age may have a lesser asset allocation in equities.

 

At age 55, the exposure to this volatile asset class should be not more than 45%.

After retirement, exposure to equities should not be more than 25-30 % of your portfolio.

 Basing one's stock allocation on age can be a useful tool for retirement planning by encouraging investors to slowly reduce risk over time.

While this easy to follow thumb rule simplifies the financial planning/retirement planning  and  it’s  very helpful in determining investors asset allocation based on age, but it may not work for everyone.

This factor does not take into account the financial position or risk taking appetite of an individual. It takes only age into consideration and assumes that all people in a particular age category will have same financial position. This may not be applicable universally, A 50 year old individual may be earning more, have higher risk taking capacity and be in a better financial position in comparison to a 40 year old person with lower income, less risk taking capacity.

Following are the key factors that one should keep in mind while deciding asset allocation strategy:

This process will help an investor in clearly determining how much money has to be invested for short term, medium term and the long-term and opt to invest in Equity stocks or Equity Mutual funds.

How much money should we save monthly?

“Someone's sitting in the shade today because someone planted a tree a long time ago. - Warren Buffett”

 We all know the importance of savings for a safe and secure future but in today’s age of instant gratification most people prefer to enjoy today than saving for tomorrow.

After getting that dream job you want to enjoy all the financial freedom your salary provides to you, however given the high cost of living most of us gradually start living from paycheque to paycheque. In order to maintain our current standard of living and be free form financial worries at later point in life, it’s very important to do savings in a disciplined manner.

Rule of Thumb # we should save minimum 30% of our income every month.

However the amount of money to be saved may vary from individual to individual depending on factors like income, age, financial goals etc.  Also saving for retirement should begin as soon as one starts learning.

For most of young people Employee Provident Fund (EPF) becomes our default savings as we cannot avoid it. Although the amount of contribution to the EPF is only a small percentage of salary, but power of compounding can turn even a small contribution into a big sum given the long investment horizon.

 

Remember that Money begets money. You must save and invest a portion of your income to make your money work for you.

Also we must not aim only to save taxes. Look at the bigger picture here, the idea is to create wealth in the long run.

 
There are many benefits if one starts saving early.  The later one starts the more amount he will have to save.

How much retirement fund we need?

Majority of people tend to ignore retirement planning as they prioritize the intermediate goals like house, car.  Retirement planning gets least focus as

 Even those who start saving for retirement often lack clarity as to how much they should save now to build a sufficient retirement corpus. People think that whatever they save during lifetime will be sufficient for retirement but they forget to take into account the effect of inflation on their savings.

The key to retirement planning is to start early and with a view to create a retirement corpus that take care of all your post retirement expenses.

Rule of Thumb # minimum 20 times of our last yearly income at retirement day should be our retirement fund/corpus.

You should have 20 times your income saved for retirement and plan to replace 80 percent of pre-retirement income. But here retirement means a retirement at age of 60 & life expectancy of 80 – and a conservative lifestyle. But now things have changed & you would have dream/planned lot of things for retirement.

How much should be our monthly EMI’s?

Rule of Thumb # total EMIs should not be more than 35% of our gross monthly family income.

Ideally total EMI on your outstanding loans should not be more than 35% of Gross Monthly income. Due to high cost of some of the major assets like House, cars one has to take loan. It should be even lesser when you are close to your retirement.

Rate of returns ideally should beat inflation:

 “Inflation is the term used to describe the rate at which prices for goods and services are rising.  It lowers the value of savings and reduces purchasing power”.

If you are saving for your children’s education expenses you might as well account for inflation. Let’s understand better from below example -

Around 15 years back, one could have completed a post-graduation (non-engineering) in Rs.30000, while now most of the private schools charge approx. the same amount as term fee for preschool.

Take another example –

Suppose a degree today costs Rs. 250,000 per annum in tuition fees.

Considering that education inflation is around 8% per annum, the same course would cost approx. Rs. 12 lakhs in next 20 years.

 We all can relate to skyrocketing prices of essential commodities and high cost of living.

You can find out how inflation can decline/reduce your purchasing power by applying Rule of 70:

70/current inflation rate= Approx. no. of years in which buying or purchasing power of your money will be half or lesser. E.g.

Inflation rate of 7% will reduce the value of money to half in 70/7 = 10 years.

Hence we need to protect our wealth. Factors like high cost of living, unstable economy make it very important for an investor to have a portfolio that aims to beat inflation.

Investing in equities for long term is one of the best ways to beat inflation. This can be done by investing in mutual funds. There are various equity funds available ranging from large-cap, small/mid-cap to diversified funds. The compounding effect of such investments will help you to beat inflation over a longer duration.

A balanced asset allocation would consist of diversified investments in Mutual funds, Gold, Bonds, Equity, Real estate. An ideal portfolio would be able to generate good returns and beat the inflation while being consistent in returns.

People tend to use banks and insurance for investments while these tools provide little protection against inflation.

Let’s see an illustration to see how inflation affects the returns from different investments:

# Use Banks for financial transactions, short term cash management and credit management.

# Use Insurance to cover the risks.

# Use Real estate for consumption (residence) or regular income (rent).

# Use Capital market to create long term wealth for yourself.

How many years double or triple our money?

Am sure most of us wonder “When will my money double/ triple”. By following below thumb rule, we can determine how long it will take to double or triple the invested amount

Rule of Thumb # Rule of 72 & 115:

 

72/Rate of return= Approx. no. of years to double the money

115/rate of return=Approx. no. of years to triple the money

 If the expected rate of return on investment is 12% then:

Rule of 72 à 72/12 = 6 years to double

Rule of 115 à 115/12 = 9.6 years to triple

This thumb rule helps you evaluate the growth of your investments and also lets you make comparisons between different investment options.

Emergency Fund:

Emergency Fund helps people deal with a financial crisis i.e. in case of any medical emergency, any unforeseen event like loss of job etc.

Rule of Thumb # we should have an emergency fund that equals minimum 6 months of your household expenditure. This money can be kept in your bank account or in a liquid fund.

“Following this simple thumb rule can buy you peace of mind.”

However the size of the fund may vary depending on following factors:

Income stability	§  A person working in private sector or a self-employed professional should have emergency fund equals to minimum 6 months of household expenditure or on higher side of the range.   §  A person working in government sector should maintain an emergency fund equal to 3 months of monthly expenses.
No. of dependents	§  In case of single income household and having parents/children as dependents higher amount of emergency fund is required.
Financial liability i.e. EMI or loans	§  In case of existing monthly EMI on outstanding loans, one needs to maintain bigger emergency fund.
Liquidity of assets	§  If an individual’s existing asset allocation is mainly in non-liquid assets like real estate, PPF, FD’s etc. one has to maintain higher amount as emergency fund.

Ensure that you don’t use this amount for day to day expenses or wants. For eg don’t use this fund to make down payment of new car or for a vacation.

 

Where to park this emergency fund:

Most people keep the emergency fund in a savings bank a/c as they consider it to be highly liquid.

However it is not advisable to do so. After separating a month’s expense in savings account the balance amount should be deposited in liquid, liquid-plus funds, short-term debt funds that offer higher returns in comparison to savings a/c.

Please refer to below chart to see the expected rate of return from various investment options:

Liquid Funds	6 to 7%	Redemption processed in 1 working day
Liquid Plus Funds	7 to 8%	Redemption processed in 1 working day
Savings A/C	4 to 6%	Money can be withdrawn 24*7
Short term debt fund	8 to 9%	Redemption processed in 1 working day

How much should we spend on buying a house?

Rule of Thumb # Cost of our house should not be more than 6 to 8 times of our family gross annual income.

The budget to purchase house is impacted by your income and loan limit. This thumb rule simplifies the complex question. The idea is that you should not be financially burdened by housing cost while you have to manage other expenses too.

Insurance planning:

Calculate your human life value and buy appropriate cover for your associated risk in day to day life i.e. 

·         Health Insurance: Buy equal to one year of your salary amount, one family health insurance cover to eliminate day to day risk to your health.

·         Buy health insurance for your parent’s equivalent to one year of your salary.

·         Term Life Insurance & Personal accident cover: Life insurance cover & Personal Accident insurance covering all types of disabilities and loss of income should be bought but separately with Minimum cover of 10 to 15 times of your gross yearly income.

·         Critical illness cover: Buy 5-10 years of your income one critical illness cover plan for self & all family members over 30 years of age

·         Buy insurance on actual current value of your assets, like house, shop, business premises, vehicle, jewellery etc.

 These thumb rules are like taking baby steps. Following these rules and adjusting them to your financial requirements will over the time create wealth for you.

 

Warm Regards

Nidhi Srivastava

&

Manish Kr Pandey

www.fernwealth.com

# +91-9830040603