The Thumb Rules of Investing
Investing can appear complicated. But there are smart guidelines that work as excellent starting points. Let's look at some essential thumb rules of investing that cuts through complexity and helps you make decisive investment decisions.
With thousands of investment choices that come in nearly infinite variations, it can be challenging to make an investment decision. The sheer number of options available and the high stakes involved in getting decisions right can overwhelm the process.
A thumb rule can offer you straightforward advice on how to go about investing. They are helpful to follow if you're looking to get an idea of how much to save, grow your money, allocate your investments and build wealth.
Let's look at some of the broad and popular thumb rules of investing to help you make the most of your portfolio.
How Quickly Your Money Will Grow
Rule of 72. A simple formula that tells you how long it will take for your money to grow is the rule of 72. It approximates the number of years it will take for your money to double, with a fixed return rate.
It's a simple formula: 72 / interest rate = the number of years it will take to double your money.
To understand how the formula works, you can plug various interest rates from different investment avenues your money is in. For instance, if your investment account earns:
- 5%, it will take 14.4 years for your money to double [72 / 5 = 14.4]
- 8%, it will take nine years for your money to double [72 / 8 = 9]
- 9%, it will take 8 years for your money to double [72 / 15 = 8]
- 11%, it will take 6.54 years for your money to double [72 / 11 = 6.54]
This rule of thumb is a practical eye-opener. It compels you to ask reflective questions before you make critical investment decisions.
Additional read: Why You Can’t Go Wrong with the SIP Method of Investing
Rule of 114. Similar to the rule of 72, the rule of 114 takes it to the next level. This rule states how long it will take to triple your money. The mathematical formula is similar to the rule of 72.
The formula is: 114 / interest rate equal to the number of years it will take to triple your money.
So, if your investment account earns:
- 5%, it will take 22.8 years for your money to triple [114 / 5 = 22.8]
- 8%, it will take 14.25 years for your money to triple [114 / 8 = 14.25]
- 9%, it will take 12.66 years for your money to triple [114 / 15 = 12.66]
- 11%, it will take 10.36 years for your money to triple [114 / 11 = 10.36]
Use this estimate to show you how long it can take to triple your investments.
Rule of 144. What's better than doubling and tripling your money? That's right, quadrupling! The rule of 144 shows you how much your money will grow four times or quadruple with a fixed interest rate.
So similar to the Rule of 72 and the Rule of 114, the rule of 144 also applies the same formula.
The formula is: 144 / interest rate equal to the number of years it will take to quadruple your money.
So, if your investment account earns:
- 5%, it will take 28.8 years for your money to quadruple [144 / 5 = 28.8]
- 8%, it will take 18 years for your money to quadruple [144 / 8 = 18]
- 9%, it will take 16 years for your money to quadruple [144 / 15 = 16]
- 11%, it will take 13.09 years for your money to quadruple [144 / 11 = 13.09]
Allocation Thumb Rules
30-30-30-10 Rule. A no-hassle, manageable thumb rule is the 30-30-30-10 rule that allows you to put your money in different types of investments. So whether you're looking to build a legacy for your children, protect your future from inflation, save for your retirement and another for your emergency fund, this thumb rule is a percentage based plan that can work for you.
In this thumb rule of investing, you allocate:
- 30% of your monthly income in equity towards inheritance
- 30% for your future in hybrid products that have equal equity and debt components
- 30% for your retirement in income bearing debt investment schemes
- 10% for your emergency fund in liquid assets
This thumb rule allows you to save and invest across your financial goals. Remember to set your financial goals, determine your net income, divide your funds appropriately and track every rupee to allow this thumb rule to work for you.
Additional read: 5 Ways to Build a Substantial Retirement Corpus
100 Minus Age Rule. A good way to determine your asset allocation is to employ this rule. The 100 minus age rule shows you how much money you need to allocate in debt and equities.
For instance, let's assume you are 25 years old. You wish to invest ₹10,000 every month. Using the 100 minus age rule, you would need to invest 75% of your money into equities [100 - 25 = 75]. That means, ₹7500 will go in equities and the remainder ₹2500 into debt.
Similarly, a 35-year-old investor looking to invest ₹10,000 can use the 100 minus age rule to allocate 65% of his money into equities [100 – 35 = 65] and the remainder into debt. That means ₹6500 into equity investments and ₹3500 in debt.
This thumb rule shows how an investor’s equity allocation reduces on retiring. So while it encourages you to decrease your risk over time slowly, you may want to adjust the 100 minus your age and take more risk with equity. That's because more and more people are living longer lifespans and getting fewer rewards from debt investments.
The 5/25 Rule. Also referred to as the Overall Stock:Bond Ratio, this rule allows you to rebalance your assets if it deviates by an absolute percentage of 5% or a relative 25%.
Let's understand this rule with an example.
Assume you have a portfolio with an asset allocation of 30% in bonds and 70% in stocks. When the stocks fall to 65% of the portfolio [bonds would be at 35%], you sell 5% of the bond allocation to purchase 5% in stocks to get back on the 70/30 blend mix.
This rebalancing works out well if you are selling bonds that have risen in price to purchase stocks that have fallen in price. In this, you are also practising the trusted investment maxim of 'buy low and sell high'.
The 25% rule comes in for those sub-asset classes that have a lower allocation.
Let's say you have a 10% allocation to small-cap stocks. In this case, the range would not be 5-15% to trigger a rebalance. That's because 25% of 10% = 2.5%. Hence, 10% plus or -2.5% comes to a range of 7.5-12.5%. Therefore, since the allocation is an even smaller part of your portfolio, you only rebalance based on the magnitude of the allocation.
The 5/25 Rule allows you to observe your investments and portfolio more closely and works well for an investment portfolio with fewer funds.
Knowing How Much to Withdraw from Your Investments
The 4% Rule. This is a popular thumb rule in retirement planning. Using the 4% rule can help you avoid running out of money during your retirement years.
This rule states that you can comfortably withdraw 4% of your savings in the first year of your retirement. You can adjust the amount for inflation every subsequent year without having to risk running out of money for at least the next three decades. This rule assumes your investment portfolio contains approximately 60% in equities and 40% in bonds.
It also assumes that you will maintain your spending level throughout your retirement years. If both these aspects hold true in your situation, the 4% rule may work for you. However, there may be no one correct answer for every investor, and hence, you need to consider this formula depending on your situation.
Additional read: The Ten Commandments of Effective Money Management In Your 20s
10% Investment Rule. As a stock market investor, knowing about the 10% investment rule is critical. This is the one rule that can help you survive bear markets.
It's a simple rule; for example, if you own an individual stock that falls 10% or more than what you paid, it’s time to sell.
Using this rule does not allow you to rationalize the loss or wait for stocks to resume prices. When you invest in individual stocks, you do so with the knowledge that getting back on track after a loss of more than 10% can be a challenging task. That's why using the 10% rule is critical, especially if the market is dropping. It helps you become a savvy investor and know when to sell a stock and when to buy it. However, this investment rule applies only to individual stocks.
Additional read: Looking to Meet Your Financial Goals? Start Here
To Know Where You Stand Financially
The Net Worth Rule. Calculating your net worth involves adding up your assets and subtracting your debts. To know your net worth, you need to:
Net Worth = Assets − Liabilities
While every individual has a unique lifestyle and individual expectations, there is no universally agreed-upon ideal number. However, you can use the following formula laid down by Thomas Stanley and William Danko, authors of "The Millionaire Next Door".
[Age] X [Pre-Tax Annual Income from All Sources, Except Inheritances] / 10 = Expected Net Worth.
The Net Worth Rule can be an important metric to gauge your financial health and give you an overall picture of your financial position. It allows you to look into your spending, saving and investing habits and make the right moves to enhance your investments already use your debt and both.
Additional read: Do you have economic moat in your portfolio? Find out here
So while these broad rules can help you take the right step when investing, it can help to know that no one size fits all. Before investing your money, it is essential to understand why you are investing.
Investing means taking on risks. And generally, the riskier the investment, the greater the potential reward. However, you will also need to accept that the investment journey may not be a smooth ride, and hence you will need to stick to your guns and stay patient regardless of market volatility to ensure long-term results.
An excellent way to ensure that you're making the right investments is to speak to a financial advisor or planner on your long-term plans. The right financial advisor can help you determine how much you need to invest and how much you can comfortably withdraw during your retirement years.