Rajas Kelkar
A lot in investing is based on the collective wisdom of the markets. There are thumb rules that somehow work. These are learnings derived from actually following the method for years. They may not be written anywhere, but the thumb rules are understood and if used, can go a long way in making your investments work for you.
Savings formula
A key issue for most people who want to start investing is in creating a surplus at the end of each month. Most people tend to put spending ahead of investing. If you speak to any financial advisor, they will tell you to invest first and then spend the remaining. There are many budget formulas available. Some say you could go for a 30-30-30-10 split of your monthly income into household expenses, investments, repayment of loans and spending respectively.
Others advise a 50-30-20 formula where you use 50 per cent of your monthly income for household needs, 30 per cent for wants and 20 per cent for investing. The point here is not the percentage split of your monthly income. The real thing is to set aside some money each month for investing. It is hard work if you are not used to doing that.
Loans formula
There are these rules that advisors would tell you about the extent to which you can borrow. Banks, typically, will offer you a home loan that has an equated monthly instalment of about 40 per cent of your net monthly income. If you have other loans, they would cut your EMI and increase the tenure. Financial advisors will certainly ask you to keep the loan component as minimal as possible. Retail loans account for just 10 per cent of the Gross Domestic product in India. Half of those loans are home loans, according to Reserve Bank of India bulletins.
This number is above 40 per cent in most East-Asian countries. It is much higher in rich nations. This clearly shows the conservative nature of the Indian households and how they look at personal loans from the banking system. Many poor households in India resort to borrowing from private moneylenders who are not regulated. They fall in a debt trap. However, if you stick with thumb rules of borrowing, you can make your money work better for you.
The investment formula
If you speak to an experienced investor, there is a good chance of that person telling you about the ‘100-x thumb rule’. So, your exposure to equity assets should be 100 minus your age. As you grow old, you should reduce your exposure to equity. Some people these days are advising investors to follow 120 minus the age. The idea is to increase the exposure to equity assets in your younger days and maximise returns on your life savings.
The exposure to equity goes down as you try to conserve your savings for your sunset years. As you grow old, you can allocate more funds to fixed income or debt funds. The purpose of this thumb rule is to explain the balance you need to achieve in your investment plan.
Emergency fund thumb rule
There is always this confusion about the amount you need to keep in your bank account as an emergency fund. Most advisors ask you to keep money equal to six months of your monthly expenses as an emergency fund. In case of an emergency, you can actually dip into your own money instead of borrowing it from anyone else. When you are in an emergency situation, you end up doing bad deals. If you lose your job, you may want to take your time to find the right alternative.
If you do not have enough savings and are repaying a loan, you may sign up for a job you do not want. When you badly need money, you may end up borrowing it from people you otherwise may not borrow from. You may also spend more on your credit cards that charge an interest rate of 40 per cent and above.
What you should do
Thumb rules have evolved over the years. They are like guiding tools you can use if you do not know much about finance. These rules are not mandatory. Every individual should adapt them to suit their risk appetite. This is your ability to take the risk. This ability is typically linked to your future income. If you are confident, you can allocate more money to equity or equity-linked assets. If you are not so confident, you may want to take a conservative approach to invest and choose fixed return instruments. It’s important to know all this and then arrive at a decision.