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Rule of 72 and other rules that make up the personal finance playbook

Rule of 72 and other rules that make up the personal finance playbook

Personal finance, as the term suggests, is a highly personal and unique aspect of one’s life. The personal finances of no two people are identical. Despite this unique nature, several popular rules of thumb have been established in the realm of personal finance management. These thumb rules address different aspects of personal finance. If the rule of 72 guides us in investments, the 4% withdrawal rule helps us manage our pension fund.

Even if it is not possible to follow these thumb rules to the T, they serve as useful benchmarks. We can use them to build our personal finance strategies around these rules. Let us look at some of the popular personal finance rules that you can implement in your everyday life.

Rule of 72

Doubling your investment always sounds enticing. The rule of 72 in finance is quite helpful in calculating this.

So, what is the rule of 72? It is a simple formula for calculating when and how to double your money. To use the rule of 72 formula, you only need the amount of investment and the expected rate of return on it. 

According to the rule of 72 formula, years to double an investment = 72/annual rate of return.

For example, let us calculate the years required to double Rs. 1000 at an expected rate of return of 9%. Calculate this in an online calculator, and you are likely to get an answer of 8 years and 14 days approximately. Now, let us look at the answer using the rule 72 investing formula.

Years to double an investment = 72/annual rate of return = 72/9 = 8 years.

Thus, the answer, as calculated mathematically and according to the rule of 72, is approximately the same, i.e., 8 years. Additionally, you must consider other factors, such as taxes and fees.

The 50-30-20 rule

This thumb rule is handy when it comes to budgeting your financial expenses for a period.

What does the 50-30-20 rule say?

  • According to this rule, you should allocate 50% of your income to needs and necessities, such as rent, food, and bill payments.
  • You should spend no more than 30% of your budget on wants, which can include discretionary expenses such as dining out, traveling, and lifestyle shopping.
  • You should use the remaining 20% of your income on debt repayments, savings and investments.

It serves as a good reference point for beginners who want to implement budgeting for their monthly income and expenses. However, it may not be possible to stick to it entirely. For instance, high rent in cities may mean that needs exceed 50% of income.

4% withdrawal rule

Moving on to the smart use of retirement corpus. There is a risk that unchecked withdrawal may lead to premature emptying of the corpus. The 4% withdrawal rule says that the maximum annual withdrawal should not exceed 4% of the total retirement corpus as on day one.

The idea behind it is that the average post-retirement life span of a person is around 25 to 30 years.

A major threat to this rule is, of course, inflation. Therefore, the remaining 96% of the corpus must be invested to beat the inflation rate at the very least.

3X emergency corpus rule

There is a personal finance thumb rule for facing emergencies as well. The 3X emergency corpus rule elucidates the importance of the rainy-day fund. The X here being your monthly expenditure, you should have at least 3 times the same in your emergency corpus.

This rule, too, is subjective, and one may argue that having 6X or 10X would be a safer approach. In a real-world scenario, an emergency corpus may be needed in the event of a job loss, for instance. You may accordingly choose to maintain the fund for that many months, as it could possibly take you to get a new job.

100-minus-age rule

This rule is related to investment decisions. As we all know, equity investments are not fully risk-free. A high equity exposure at an old age can be a very risky proposition. This is because the equity market in most countries delivers long-term growth with short-term volatility.

Therefore, a long-term investment is more likely to deliver high growth. However, a short-term exposure may not have sufficient time to recover from an ongoing slowdown in the market.

Coming to the rule, it simply states that your equity allocation should be 100 minus your age. Thus, if you are 40, your equity allocation can be 60%. But if you are 70 years old, your equity exposure should not exceed 30%.

Concluding thoughts on personal finance rules

If you are planning to implement any or all of these rules, here are a few key takeaways for you.

  • Rule of 72 – Use it to understand the power of compounding and/or growth of investment. The limitations of the rule related to tax implications and the 5-10% range must be kept in mind.
  • 50-30-20 – Manage your monthly expenditure with this rule, but keep in mind that your essential expenses may be more in an expensive city. To secure yourself financially, ensure that you maintain or even maximize the 20% earmarked for savings.
  • 4% withdrawal – Use your retirement corpus diligently with this rule. Make sure your corpus continues to grow. This will ensure that its worth doesn’t erode due to inflation.
  • 3X emergency corpus – Build an emergency corpus for times of trouble. Don’t assume that 3X is sufficient in your case. Decide on your emergency fund size after due consideration.
  • 100 – Age rule – This rule will help you consider the risks associated with equity exposure. It discourages investors from recklessly investing in the equity market. However, this rule overlooks your personal risk profile and market expertise.

Personal finance rules help you calculate and decide your investments, equity exposure, monthly expenses, use of retirement corpus, etc. These rules will also help you save more and spend less in your everyday life. To save money and put these rules into action, explore Tata Moneyfy, Tata Capital’s digital wealth platform that helps you plan, invest, and monitor your portfolio for steady, well-informed growth.

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FAQs

What is the rule of 72 concept?

The rule of 72 is a simple personal finance rule that helps you calculate and find out the number of years it will take to double your investment amount, for a particular rate of return.

How does the rule of 72 work?

To calculate the year needed to double an amount using the rule of 72 formula, you have to divide the number 72 by the expected rate of return.

Is the rule of 72 only for investments?

Apart from the positive growth of investments, it can be used for negative growth calculations as well. For instance, you can use it to calculate the number of years it would take for a commodity to cost you twice the money, for a given inflation rate.

Where is the rule of 72 commonly used?

The rule of 72 is used to estimate the doubling of money in investments and wealth building, calculate your future purchasing power, for population growth, GDP growth and a variety of similar calculations.
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