Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
The last post, the first one of this series, “The Rule of 72”, was received very well by the readers and all felt that this simple rule can do wonders towards one’s own financial planning. This post takes fun financial maths forward. Read on.
Fun Rules of Triple 15, 50:50 and 5:25
The first fun rule is the “Rule of Triple 15” which you could use to calculate long-term returns from your investments, including mutual, funds mentally. It goes like this – If you invest Rs 15,000 per month for 15 years and manage a rate of return (ROR) of 15% (a tall order, I must say), you become a crorepati. Yes, your corpus touches the magic figure of Rs 1 crore with the investment of only Rs 27 lakh. You can do mental math to get variations of this rule. For example, a 15*15*30 rule – if you invest Rs 15,000 per month, getting ROR of 15% for 30 years duration, your corpus grows to a humongous Rs 10 crore. So, please internalize the rule of 72 and triple 15 to harness the power of compounding in your personal finances.
The Second Rule is Sir John Templeton’s “Rule of 50:50”. This is a powerful rule which is a variation of the concept of “pay yourself first” which I had elaborated upon in my earlier posts entitled “The Richest Man in Babylon”. For those who don’t know Sir John Templeton, he was an American billionaire investor who, in 1999, was called “arguably the greatest global stock picker of the century” by the Money magazine. His 50:50 rule was straightforward – for every dollar of spending by him, he will save one dollar. In its very essence, the rule talks of a 50% savings, i.e. one must live on only 50% of one’s income and save balance 50%. If you find this difficult to follow, there is more to come. Sir Templeton also said that if he had to buy, say, a TV worth Rs 50,000, he first had to save another Rs 50,000 and set it aside as investment. Imagine how difficult it will become when you have to buy a big-ticket item like a car or a house. But Sir Templeton followed this rule in the letter and spirit, and that is what made him a billionaire. Incidentally, this rule of 50:50 is again gaining popularity in the form of the FIRE (Financially Independent Retire Early) movement nowadays – more about FIRE in one of my subsequent posts.
The next fun maths is on how to calculate the time required to build up a “Breathing Fund”. I have covered this concept at length in my books – the “Breathing Fund” (also called Emergency Fund), is a saving equivalent to roughly six months of your expenses, set aside for financial emergencies, which becomes the building block of your future wealth. The importance of this Breathing Fund was brought to fore during the ongoing pandemic when people lost jobs or had to take massive pay-cuts. So, if you want to roughly calculate the time it will take to save six months’ worth of expenses as you are building your Breathing Fund, simply take the percentage of take-home pay that you intend to spend (say 80%) and divide it by the percentage of what you intend to save (say, 20%). The result, four months (80/20), when multiplied by 6 (number of months for which you want to cater) gives you the time required to save six months’ worth of expenses, i.e. 24 months. If you save only 10% of your income towards building your Breathing Fund, the time increases to 54 months ((90/10)*6). Of course, this is just a thumb rule, and the final results may slightly vary based on the ROR that you manage with your savings. Always remember that the Breathing Fund is for your expenses, which must include your EMI/SIP etc. because savings and investments should never stop – not even for one month.
That brings us to the next rule of this post – Warren Buffett’s “Rule of 5/25”. I am sure that all of you would be familiar with Warren Buffett, an American business magnate, investor, speaker and philanthropist who serves as the chairman and CEO of Berkshire Hathaway. He is considered one of the most successful investors in the world and has a net worth of US $ 76.3 billion as on October 30, 2020, making him the fourth wealthiest person in the world. Incidentally, Buffet has promised to donate over 99% of his wealth in philanthropy and has so far donated more than $ 41 billion. Let me put this amount in context – it is nearly half of the net worth of Mukesh Ambani (India’s richest) and double of that of Gautam Adani (the second richest Indian.)
Folklore says that Buffett gave this rule of 5/25 to his airline pilot Mike Flint. Buffet told Flint to write down his top 25 goals in life quickly (without overthinking) and then deliberately strike out the bottom 20, which admittedly would have been a more difficult task for Flint. He then asked Flint to only concentrate on the balance (top) five goals, meaning firmly saying “No” to any activity which takes him away from his top five goals. This elimination gives you the power of focus and is a variation of the famous “80:20 Rule” (Pareto’s Principle).
In your financial life too, you must earmark five activities/habits which make/save/invest money for you and concentrate on these. At the same time, identify five activities/practices where you tend to waste money and ruthlessly eliminate them from your life. You might be thinking this activity to be an exercise in futility but remember that an ocean also consists of only drops – billions of them. In fact, I will soon write a post on “Magic of Small Savings”, to prove this point.
We all make regular investments but find it difficult to keep track of their performance over time. This lack of tracking results in remaining invested in losers which bleed our financial future. Let us learn a quick way to analyse any investment. Just take the investment’s beginning and ending value (on the date you wish to calculate) – let’s call these values as B (beginning) and E (ending). The formula to calculate the gains/losses of this investment is (E-B)/B. So, if you invested Rs 10000 in a mutual fund and its current value is 12000, your gains are (12000-10000)/10000= 0.2 or 20%. Conversely, if you had invested Rs 12000 in this mutual fund and its value is now only 10000, your loss is (10000-12000)/12000= 0.16 or 16%.
The last fun financial maths is to mentally calculate your “Break Even Rate of Return”. We all invest in various instruments like equity (stocks, mutual funds, ETF, Index funds etc.), debt (mutual funds, bonds, FD etc.), gold, real estate et. al. As is the norm, all these investments don’t move up or down together. When equity does well, debt may be giving subdued returns and vice versa. This is the logic of the concept of “Asset Allocation” about which I have extensively written in both my books. All our investments, taken as a whole, are called our “Investment Portfolio” and we should always look at the returns from this portfolio as a whole and not cherry-pick individual investments. Then there is also the issue of inflation and taxes which will impact the final returns, so how do we mentally calculate the “Break Even Returns” (is our investment portfolio as a whole making money?) from our investment portfolio after catering for taxes and inflation?
For the example here, we assume that the Retail Inflation is likely to be 6% (incidentally, this is the upper mandated limit by the RBI) and the tax bracket is 30%. So, we divide the assumed inflation rate i.e. 6% by 1 minus the tax bracket (30% in this example). So, this profile of investor would need to earn at least 8.5% returns (6/(1-0.30) to break even after inflation and taxes. See how tall is the order here? Very clearly, a 100% debt portfolio will never earn you this kind of returns and hence equity exposure is a must. The alchemy of long-term wealth creation lies in prudent Asset Allocation, which you must understand and internalize. As mentioned above, I have dealt with this all-important aspect at length in my books.
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