Wealth Creation for Generations: 2024-06-16

Wednesday, June 19, 2024

Thumb Rules for Investing

Thumb rules are aimed at beginners in the field of Savings & Investments. In my experience, some of these rules provide a good baseline; but based on risk tolerance, time horizon, and individual circumstances, there may be reasons why a financial rule of thumb may not align perfectly with an individual investor’s circumstances.

Altogether there are 14 thumb rules on different aspects of investing listed below:

TR#1. Emergency Fund Rule: Prepare for the Unexpected

As the name suggests, the money kept aside for emergency use is called an emergency fund. It is a good practice to keep six months to one year’s expenses as an emergency fund. While calculating your expenses you should include expenses for food, utility bills, rent, EMIs etc. And instead of keeping it idle in savings bank accounts invest in liquid funds. These funds provide a little more returns than savings bank accounts. At the same time, like saving banks accounts, liquid funds are highly liquid, i.e. the money is available in very short notice

Some experts keeps minimum period as 3 months. Pl understand that Emergency Fund is to keep going till another equivalent or better income source materializes. It depends upon the individual’s profile and related job market.

In the current circumstances, 3-6 months salary /expenses may be appropriate compared to Covid-19 period, when 6moths to 1 year was expected

TR#2. The 10,5, 3 rule: What kind of returns one can expect from their investments.

The 10,5,3 rule offers a simple guideline. Expect around 10% returns from long-term equity investments, 5% from debt instruments, and 3% from savings bank accounts.

Aim to save at least 10% of your current salary for retirement, increasing it by another 10% each year. This disciplined approach can help you build a substantial retirement corpus over time.

TR#3. Rule of 72: Doubling Your Money

A simple formula that allows you to estimate the time it takes for an investment to double in value. Divide 72 by the annual rate of return on your investment, and you'll get the approximate number of years it will take to double your money. For example, if you're getting a 6% return, your money will double in approximately 12 years.

The Rule of 72 is a powerful tool because it gives investors a quick way to assess the potential growth of their investments. By understanding this rule, investors can make more informed decisions about where to allocate their capital and how long to hold their investments.

TR#4. Rule of 114: Tripling Your Money

The Rule of 114 tells you how long it will take for your money to triple. Similar to the Rule of 72, divide 114 by the rate of return to find the number of years. With a 6% return, your money will triple in approximately 19 years.

Tripling your money may seem like a distant dream, but understanding this rule can help investors set realistic goals and make strategic investment decisions.

TR#5. Rule of 144: Quadrupling Your Money

For those who dare to dream even bigger, there's the Rule of 144. This rule tells you how long it takes for your money to quadruple. Divide 144 by the rate of return, and you'll know the number of years it will take. At a 6% return, your money will quadruple in about 24 years.

TR#6. Rule of 70: The Impact of Inflation

How much time will take my corpus to loss 50% in value, if inflation is known?

For example, let’s suppose you have Rs 50 lakh and the current inflation rate is 5 percent. So going by the rule of 70, your Rs 50 lakh will be worth Rs 25 lakh in 14 years.

TR#7. Budgeting Rule

Your Income is divided in the ratio of 50:30:20= Needs: Wants: Savings

U.S. Sen. Elizabeth Warren popularized the 50/20/30 budget rule in her book, All Your Worth: The Ultimate Lifetime Money Plan. The rule is to split your after-tax income into three categories of spending: 50% on needs, 30% on wants, and 20% on savings

TR#8. 100 Minus Age Rule: Asset Allocation

For example, say you are 25 years of age. In that case, the asset allocation for your portfolio according to the ‘100 Minus Age Rule’ will be as follows:

· Equity: 75% (100 - 25 years)

· Debt: 25%

Similarly, for a 40-year-old investor, the asset allocation will be as follows:

· Equity: 60% (100 - 40 years)

· Debt: 40%

TR#9. The 10% Rule for Long Term requirements like Retirement

Starting to save from your first salary, no matter how little the amount is, you will be able to create a huge corpus for retirement. And ideally it should be 10 percent of your current salary which you should increase by another 10 percent every year

Example

Calculating Retirement Corpus
Current age	25
Investment amount every month	₹3,000
Percentage of increase in investment amount every month	10 percent
Average rate of return	10 percent
Retirement age	60
Tenure of investment	35
Total retirement corpus	₹3.4 crore

So, simply by investing Rs 3,000 every month, and stepping it up by another 10 percent every year, you would be able to create a corpus of Rs 3.4 crore.

TR#10. Life insurance coverage 5 to 10 times your income

A life insurance policy that covers 5 to 10 times your annual pretax salary may be enough to help protect your family if something should happen to you.

TR#11. The 7-5-3-1 rule of SIP

The Systematic Investment Plans (SIPs) has long been popular among investors looking to build wealth over the long term. With a disciplined approach to investing, SIP is an automated investment plan that allow individuals to invest small amounts in their chosen mutual funds regularly.

While SIP investment is a simple means to grow your funds over time, market volatilities can affect your investment returns. At such a time, being steady with your investment strategies can help you maximise your SIP returns. One such effective strategy is the 7-5-3-1 rule of SIP.

The Period=7 year

Historically, equity investments are known to perform better in the long run, and having a minimum investment period of seven years allows your investment to grow by capitalizing on the power of compounding. In the short-term, the stock market can be highly volatile, which might not allow your investment to sustain the fluctuations and generate decent returns. So, being patient with your investment with a seven-year horizon gives your funds the time to grow and turn the regular SIP payments into a substantial corpus over time.

Portfolio with the 5-finger framework

A critical aspect of investing in equity funds is diversification, which allows you to build a stable portfolio over time. The 5-finger framework aims to deliver superior returns and minimise risk with a diversified portfolio across various asset classes and investment strategies.

This includes spreading your investment based on 5 areas-

A. Quality: Invest in the stocks of well-established companies that have a history of strong, favourable performance. Such high-quality stocks help stabilise your investment during volatile times.

B. Value: Value stocks are the under-valued stocks in the market with a high potential for great returns. These stocks typically trade at a price lower than the inherent value of their company, but offer good value for money.

C. Growth at reasonable price: These stocks offer high growth potential at low market volatility.

D. Mid/Small cap: Mid and small cap companies hold immense growth potential and can generate substantial returns for the investors. They diversify your portfolio by adding a different market cap segment.

E. Global: Investing in global stocks can offer untapped opportunities for growth and provides a hedge against domestic risks.

the 3 phases of investment cycle

While SIP investments in equity funds tend to yield decent returns in the long term, you must be prepared to survive the three inevitable phases of failure in the beginning of your investment journey.

A. Disappointment phase: During this phase, you might encounter subpar returns (7-10%).

B. Irritation phase: In the next phase, your investment returns might drop even lower than expected (0-7%)

C. Panic phase: This is the phase where your investment returns become negative

These phases can occur due to volatility in the market. However, they are only temporary and the market tends to recover over the next few years.

Increase SIP amount after every 1 year

What makes SIP an attractive investment strategy is the ability to start small. However, gradually increasing your investment amount – specifically after every 1 year can make a big difference to your portfolio value in the long run.

TR#12. Another related rule is 100 installments holds the key.

This almost aligns with the TR#11 above as 100 installments per month translates into apprx 8 years plus.

TR#13. The 4% Withdrawal Rule: Sustainable Income

During retirement, it's essential to ensure a steady income stream while preserving your savings. The 4% withdrawal rule suggests withdrawing no more than 4% of your retirement corpus annually. Adjust this amount for inflation to maintain purchasing power.

This rule helps retirees strike a balance between enjoying their retirement years and ensuring their savings last a lifetime.

For example, if you have a retirement corpus of ₹2 crores, you need to manage your expenses in such a manner that your annual spending is limited to ₹8 lakhs.

TR#14. The Net Worth Rule: Assessing Wealth

Multiply your age by your gross income and divide by 10 (or 20 in India). If your net worth exceeds the result, congratulations – you're wealthy!

In India, the experts say the divisor should be 20 instead of 10. So for example, if you are 30 years old and your gross income is Rs 12 lakh, then your net worth should be at least Rs 18 lakh to be called wealthy.

Happy Investing

Risk Profiling of Investor Vs. Risk of Mutual Fund Scheme

The number of unique mutual fund investors is up from 37.9 million (April 2023) to 45.2 million (April 2024), an increase of 19.3 per cent, according to the Association of Mutual Funds in India (Amfi) data. A poor experience early in their investment journey could turn many of these newcomers off equities for a long time, which is why they must enter the market cautiously.

One can understand the risk profile as the quantification of risk tolerance of an individual.

Every individual investor is unique. Not only with regards to investment objectives but even in approach and view of risk. This is what makes Risk Profiling absolutely crucial before investing.

A Risk Profiler is essentially a questionnaire that seeks an investor’s answers to questions about both “ability” and “willingness”. It is highly recommended that investors contact their Mutual Fund distributor or an investment advisor to complete this task and get to know their Risk Profile.

Every individual has a different tolerance to market Volatitilty, the gauge of how fast the value of securities or market indexes moves up/down or risk based on several factors like disposable income, age, et al. Therefore, risk profiling helps both an investor and financial advisor to create a specific investment portfolio with an asset mix correlating to his risk profile.

Organisations also use the term ‘risk profile’ to define the potential threats to which it is exposed. In the AML/CFT universe the firms undertake such analysis regularly. By identifying the risk profile, organisations can take corrective or pre-emptive measures to minimise, and sometimes, even avert impending losses. However, the term’s predominant use is found in the context of an individual’s risk tolerance.

Risk tolerance, on the other hand, refers to an investor’s willingness to take risks or the level of volatility in returns one is ready to deal with.

Investor’s risk is profiled keeping in mind multiple factors such as your habits, behaviours, family orientation, attitude towards risk, age etc. Risk appetite refers to the amount of risk you have the capacity to absorb, and this broadly helps determine the asset classes (equity, debt, gold, etc.) and style of investment that you are comfortable with (growth, value, etc.).

Investor’s risk profile

Your risk profile is broadly a factor of:

1. Your risk capacity,

2. Your risk tolerance and

3. The risk you need to take to achieve your planned financial goals.

Your risk capacity or in other words your ability to take risks depends on factors that can be quantified (your age, income, number of dependants, etc.).

Risk tolerance or your willingness to take risk indicates your emotional tolerance towards the ups and downs in the market and towards risk taking in general. This is essentially a psychological characteristic.

Required risk, is a mathematical calculation under a set of assumptions that helps you understand the level of risk you will need to take, to achieve your financial goals. Some experts may consider required risk to be a part of an individual’s risk capacity, which is essentially a financial characteristic.

Every investor has a unique perception of risk. Therefore, measuring the risk appetite of an investor is vital for risk profilers. They do this to ensure that you are not sold a riskier mutual fund than you can handle. To measure your risk appetite, risk profilers evaluate your Need, Ability, and Willingness to take a risk.

Investor’s 'need' to take risks arises when you aim for higher returns to reach certain financial goals.

Similarly, the ability to take risks depends on one’s financial profile (like your remuneration, number of dependents and more) and the investment horizon.

Lastly, the willingness to take a certain amount of risk depends on how much risk you can psychologically handle.

Investors often vet their financial standing, i.e. balance between assets and liabilities, to evaluate the level of risk they can take.

Financial advisors also utilise the asset-liability balance of an investor as a towering factor of risk profile determination.

For instance, an individual who has several assets at his/her disposal in comparison with very few liabilities will likely be a risk-seeker.

An individual with sufficient retirement capital, emergency funds, and no loans will be in that category.

Since such investors’ financial standing would not suffer greatly due to short-term market volatilities, they can afford to look at the bigger picture of exponential returns at that cost.

However, an individual whose asset value is not all that substantial, but his/her liabilities count is significant will most likely be risk-averse.

This category of investors possess limited adjustment space in their budget for accommodating loss from short-term volatilities and will be definitely more inclined to look for a safe investment haven.

One should note in this context that a healthy share of assets and fewer liabilities does not always prompt an individual to undertake a risky investment approach. It strictly depends on an individual’s own psychology of risk in that case.

Major Factors influencing an Investor's Risk Profile

Here are a few factors other than the asset-liability screen that have a bearing on risk profile:

1. Age

A young investor with minimal responsibilities can think of putting more money into riskier investments. A family-man may need a different approach, and someone nearing retirement may best approach investing conservatively.

2. Income

If you have a regular, stable income to support your lifestyle and your future prospects are bright, you can consider taking a higher risk when investing to earn higher returns.

3. Investment Horizon

If your financial goal is far out, you can afford to take risks now as you have the opportunity to ride out short-term fluctuations in the market by staying invested for a longer duration.

4. Emergency Fund

It is recommended to have at least 6-8 months of expenses, including EMI, for contingencies. Having a sufficient corpus will allow you to take more risks in investing.

5. Insurance

It is mandatory to have adequate life insurance before you start taking risks with your money. A health cover helps avoid dipping into your savings in cases of medical emergencies.

6. Family Wealth

Surplus money that you can put to good use and earn more can be invested in riskier instruments. However, if a loss of that wealth will stretch your finances, it is better to invest conservatively.

7. Experience

Investors who have made successful investments are generally comfortable taking higher risks than someone who has made losses, or is a beginner.

8. Knowledge

This is the best investment one can make. Your understanding of a financial product and how the markets work determines your willingness to take risks. The higher your knowledge, the higher can be your risk appetite and vice-versa.

Difference between Savings& Investments

The biggest difference between saving and investing is the level of risk taken. Saving typically results in you earning a lower return but with virtually no risk. In contrast, investing allows you the opportunity to earn a higher return, but you take on the risk of loss in order to do so.

Though both are strategies to create wealth ,here are the key differences between the two — and why you need both of these strategies to help build long-term wealth.

Deferring consumption is common feature in both strategies. Investment starts where you have covered your living expenses, with or without provision for emergency funds. Investing is money that you’re planning to leave alone to allow it to grow for your dreams and your future.

A savings account or bank fixed deposits are some of the popular savings options in India. It is similar to holding cash. You Only Live Once (YOLO) trend leaves people in financial problems in future.

Saving is merely the difference between income and expense. While investing is allocating part of the savings towards assets to create long term wealth. It would help if you strategically coupled your savings with investments to be able to generate significant returns.

The table below gives a comparison between Savings & Investment

Particulars	Savings	Investments
Purpose	Meeting Emergencies	Earn Return on money invested
Time horizon	Short	Long Term
Difficulty	Easy to deal with like SB account	Hard- Stricter procedures , disclosures
Risk	Bank account – Risk covered by Deposit Insurance and Credit Guarantee Corporation (DICGC) upto Rs 5 lakhs	Risk varies from less risky Govt Bonds to high risk Equity. Risk management tools are available ; but no guaranteed returns or even principal amount.
Protection against inflation	NO	Potentially over long term, guard against inflation
Liquidity	Very high	Not very liquid
Expenses	Not really matters	Fees , Taxes are accompanied in varying measures

Needs, Wants and Savings

Two key takeaways here that gain prominence when it comes to investing:

When what you can afford is more than what you want, listen to your wants, and
When your wants are more than what you can afford, go with what you can afford.

Certain questions you can ask yourself to figure out where you stand on the risk-o-meter.

For how long are you planning to invest?
How do you foresee your income in the future?
How many years do you have until retirement?
Do you own the house you live in?
Is your emergency fund full?
Are you comfortable with stable investments, or do you seek potentially high returns?

Example of Risk Profiler Tools

1. Risk profiler tool by Mirae AMC

2. Risk Profiler tool by ICICI AMC

The risk profile of Mutual Fund Schemes

Now that your risk profile is evaluated, it can be matched with that of the mutual fund you wish to invest in.

The risk profile of a scheme is the degree of risk attached to the principal invested. For this, you can refer to the risk profile disclosure on the first page of a mutual fund's scheme information document (SID). To better understand, you can also refer to the pictorial representation of your fund's risk profile in the riskometer.

Riskometer

A riskometer defines the risk to the invested principal in a pictorial form. It is a 180-degree line with an arrow pointing at a particular risk category or level. The risk levels mentioned on the riskometer starting from its left to the right side are as follows:

Low
Low to Moderate
Moderate
Moderately high
High
Very High

Looking at these categories, you can understand the risk to your principal.

Examples of mutual fund types and risk

Looking at the lower risk level, there can be non-equity based mutual funds, particularly those offering higher liquidity—for example, liquid mutual funds and overnight funds.
Then, there are funds with moderately low risk. These schemes can invest in debt, fixed-income and certain equity-based securities—for example, fixed maturity plans, debt-oriented schemes involving capital protection and certain arbitrage funds
Going one level ahead to the moderate risk category, conservative monthly income plans and income funds are examples of the moderate risk category
Next, there is the moderately high-risk category. Index funds, ETFs (Exchange Traded Funds) and solution-oriented funds are examples of funds that come under the moderately high-risk level.
Sectoral or thematic funds are examples of high-risk funds.

Many are investing only in mid and smallcap funds, without realising that returns tend to be cyclical. If these funds do not do well in the near future, they might get disillusioned and quit

Concentration risk both on the Liability & Asset sides is displayed on AMFI site . This is a moving target and normally found disclosed at the respective fund’s website

Happy Investing

Wealth Creation for Generations

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