Recently, I came across a message on one of the social media platforms about various thumb rules in financial planning. I was amazed to see how otherwise smart people fall prey to various short cuts.
Let us analyse one of those thumb rules.
• 100 minus our age should be our equity allocation.
Though this one is very popular, I am not sure how many actually implement this. Thank God, if they don’t follow it blindly.
Let us assume for a moment that this is right. How much should be allocation to equity for a 103 years old person? Stumped?
Let us look at a variant of this one. Someone argued that for the Indian conditions the rule should be modified as Equity allocation should be equal to 80 (or some say 70) minus one’s age
This 80 (or 70) is the average expected age of Indians at death. The greatest flaw in this equation is to link longevity with equity allocation, as if there is a relation between the two.
When such simple questions can stump it, how strong is the thumb rule? What purpose do these serve?
For that, let us start with understanding what “thumb rule” means.
As per Wikipedia, A rule of thumb is a principle with broad application that is not intended to be strictly accurate or reliable for every situation. It is an easily learned and easily applied procedure for approximately calculating or recalling some value, or for making some determination.
The meaning says a lot about the applicability. The rules of thumb are broadly applicable. However, that does not mean they apply in all scenarios. At the same time, these should apply mostly. It cannot be arbitrary without any scientific backing of data or logic.
Let us look at another rule of thumb – another popular one widely used in personal finance – the rule of 72. This rule allows us to calculate the number of years it takes to double your money given a rate of return.Number of years to double your money = 72 divided by rate of return (% p.a.)
If the rate of return is 9% p.a., it would take roughly 8 years to double your money. Let use put the numbers in the equation of compound interest:
P = Amount invested = Rs. 100 (assumed)
r = rate of return = 9% p.a.
n = time period = 8 years
A = amount accumulated = P * (1 + r) ^ n
Solving the above equation would give us
A = 100 * (1 + 9/100) ^ 8
= 100 * (1.09) ^ 8
= 199.25, which is roughly equal to double of the original investment
The rule of thumb passed the test. We could take any other combination and check that most of the time the rule turns out to be true.
However, the rule we started with is about what an investor should do – how much money should be allocated to equity. Since this does not talk about what to expect out of such allocation, there is no way to check whether the rule proves right – whether always or never.
Broadly, the rule indicates that older investors should have lower allocation to equity. However, such a generalization does not give any weightage to the investor’s unique situation, or any other parameter than the age of the investor.
Let us look at an example. There are two investors, in both cases the man is of 50 years each. Their wives are of 48 years each.
1. One has a family of six to support – the couple plus the parents of both the husband and the wife. Both are working in private sector companies, which offers no pension on retirement and the retirement age is 60 years. They have no children.
2. The second family consists of husband and wife plus one college going daughter. Their parents are no more. Both are working in Government offices and are entitled to family pension for life.
Can these families have same allocation to equity?
It is important to check whether something presented as a rule of thumb is really one or is it just a trivial short cut?The author runs Karmayog Knowledge Academy. Views expressed here are his personal views. He can be reached at firstname.lastname@example.org.