Here are a few commonly used rules of thumb categorised into mathematical, financial advice and mythical.
There are some rules that are true due to mathematical properties:
Rule of 72: This rule (written as 72/r) helps one determine the number of years it will take to double money, where r is the annual compounded rate of interest. If a bank offers you 8% p.a. compounded annual rate, then you can expect your money to double in approximately nine years. Similarly, in the earlier days of money doubling in five years, the implied annual compounding rate was around 14.2%.
Real rate is twice ‘flat rate’: Many agents sell loans at a rate which appear mouth watering. But look closely and the fine print will say that the calculations are based on “flat rate”. Flat rate means that the interest is linearly (or simply) calculated, rather than on a reducing balance method.
For example, if you take a five-year (60 months) auto loan of Rs. 3,00,000 and the EMI is, say, Rs 6,335, the total payment will be Rs 6,335*60 months = Rs 3,80,100, implying that the interest paid is Rs 80,100 over the next 60 months.
The wrong (or the flat) method of calculating interest is to say that the annual interest paid is Rs 80,100/5 years = Rs 16,020, and hence the interest rate is 5.34% (Rs 16,020/Rs 3,00,000*100).
If you calculate the interest based on the reducing balance method, which is what banks actually do, then the real rate of interest works out to 10.18%, which is roughly twice (10.18%/5.34%=1.91) the interest rate that the agent will tell you. It is mathematically true that the real rate is approximately twice the flat rate.
Financial Advisors’ Rules
These rules help the advisor in devising a strategy for you.
Term + Mutual Funds > ULIPs: Bundling insurance and investments is typically not a good idea. A ULIP can be deconstructed into a term plan (pure risk cover) and an investment portion. Buying a term plan with the insurance company and investing the balance amount in a choice of mutual funds will typically yield you a better performance.
Debt outflows should be limited to 50% of your income: You would have noticed that banks offer loans of up to 48 times your monthly salary. Have you wondered why? Let us see: If you take a loan at 10.5% interest for 20 years, then the EMI per Rs lakh is Rs 1,000.
Assume that your monthly salary is Rs 10,000. Banks, following this rule of thumb, will expect that you can pay up to Rs 5,000 as EMI. Hence, they can offer you a loan of up to Rs 5,00,000. Incidentally, this amount is approximately 48 times your monthly salary!
If the bank realises that you are paying EMIs on other loans (like car or education loan), they will reduce the quantum that you are eligible for such that not more than Rs 5,000 of your income is used towards debt servicing. Anything more, and when the good times stop, you may be in a financial mess!
These rules have emerged to make life very simple for the financial decision maker. Since they are over simplified, these rules very quickly lose their relevance on digging further. Be careful when using them!
100 minus your age in equities: This rule states that the allocation of your portfolio in equities should be a decreasing function of your age. So at the age of 30, you should be 70% invested in equities and at 70, 30% of your portfolio should be in equities.
While a good starting point, the actual portfolio allocation should depend a lot on your needs, upcoming milestones, special situations that you might have and your risk tolerance (ability and willingness). Hence, your advisor may recommend that even at the age of 30, you should be invested only 30% in equities, depending on your circumstances.
10 times your annual salary as insurance: The issue with life insurance, as opposed to non-life, is that it is very hard to put a financial amount to any one’s life. Hence, a rule-of-thumb says that your insurance should provide coverage worth 10 times your annual income: even if the life insurance corpus earns 10% return after you are no more, your family will get your income.
Again, this is a good starting point, but not complete. For example, it does not take into account inflation, the corpus that you have already built up and the change in circumstances once you are no more. A better way is to calculate the Human Life Value (HLV) or ascertain the liabilities that you have to meet and cover them all. Your financial advisor can help you determine the amount of insurance that you need.
While it is good to have rules-of-thumb, it is important that you understand the underlying financial calculations. A detailed discussion on why your advisor is using a rule-of-thumb, will yield a lot of insights into your financial plans!
Akhilesh Tilotia, Park Financial Advisors