Sunday, February 20, 2011

10 Commandments

10 Investing Thumb Rules

Back of the envelope calculations may not be accurate to the last decimal but they give you a fair idea of what you are looking for. Here are some immutable financial rules that can help you with quick estimates. Use them to get a grip on your finances and make informed investments decisions.

** These rules provide only a rough idea. The actual amount after compounding may vary.

Rule of 72:
This tells you in how much time will your money double. Divide 72 by the interest rate you are compounding your money with and you will arrive at the number of years it will take to double in value

Rule of 114:
Use this to estimate how long will it take to triple your money. It works the same way as the rule of 72. Divide 114 by the interest rate to know in how many years will Rs 10,000 become Rs 30,000.

Rule of 144:
Similarly, this tells you in how much time will your investment quadruple in value. For instance, if the interest rate is 12%, Rs 10,000 becomes Rs 40,000 in 12 years.

Rule of 70:
This is a useful rule for predicting your future buying power. Divide 70 by the current inflation rate to know how fast will the value of your investment get reduced to half its present value. This is especially useful for retirement planning, as it affects the way you set up your monthly withdrawals. However, do remember that the inflation rate varies from time to time.

The 10,5,3, Rule:
This is a neat little rule that states that you can expect returns of 10% from equities, 5% from bonds and 3% on liquid cash and cash-like accounts.

The Emergency Rule:
Put away at least 3-6 months worth of expenses in a liquid savings account to ensure it is available at short notice
4% withdrawal Rule:
How much should I withdraw during retirement? We often use the 4% rule to protect the principle and determine how much one can take from the retirement savings. If every month you withdraw Rs 50,000 you need a corpus of Rs 1 crore (Assuming that the corpus earns 9% and the inflation rate is 6%) to sustain monthly withdrawals for the next 25 years.

100 minus your age Rule:
This rule is used for asset allocation. Subtract your age from 100 to find how much of your portfolio should be allocated to equities.

Pay yourself first Rule:
Right from your first salary, put away a little for your retirement. Experts say 10% of your income should go into this. It is important to increase the amount as your income rises over the years. In every month you invest Rs 5,000 in a plan that grows 8.5% annually and increase your investment by 10% every year then after 30 years you will have Rs 2.5 crore.

Are you Wealthy ?
Do you consider yourself wealthy? A rule-of-thumb formula used by Thomas J Stanley & William D Danko  in The Millionaire Next Door, a book that studies selfmade American millionaires, can help determine if you are.

(Age x Pre-tax income) / 10 = Net worth

The logic behind the formula is that the older you are and the more money you make, the more net worth you should have. Dividing by 10 is the rule-of-thumb that fits American conditions. So, if you are a 35 year old living in the US with an annual income of $6,00,000 a year, your net worth should be $2.1 million [(35 x 6,00,000) / 10 = 21,00,000] for you to be considered wealthy. If you are 20 years old and you make $3,00,000 a year, you would be wealthy if your net worth was greater that $6,00,000.

Indian Context: Indian financial experts argue that a divisor that's closer to 20 would be more realistic in the Indian economy. According to them you should use a sliding scale linked to age. At age 40, someone earning Rs 7,50,000 a year should have a net worth of Rs15,00,000. For a 20 year old, the divisor should be 25. Hence a 20-year-old earning of Rs 3,00,000 a year should have net worth of Rs 2,40,000.

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