Whenever someone mentions the word rules, most of us want to run in the other direction. It's not that we're rebellious by nature; it's just that rules are no fun and, well, breaking them usually is. But there's something really great about financial rules of thumb: They work. In most cases, following them will help protect you from risk and maximize your investment potential.
Following are some important money rules to keep in mind as you budget your expenses, save money and invest for your future. These are rules you won't want to break.
Rule 1: Follow a budgeting formula
Balancing your expenses against your salary is nearly impossible without a strategy to stick to. To determine how much to spend on various expenses, follow this formula recommended by top experts:
- Try to spend no more than 30 percent of your take-home pay on all your housing expenses. This includes any combination of rent, renter's or homeowner's insurance, mortgage payments, property taxes and homeowners association or co-op fees.
- Allocate an additional 15 percent to transportation expenses, including car payments, bridge tolls, insurance, parking, cab fares or anything else related to getting you from place to place.
- Plan to set aside about 10 percent of your monthly income for savings, whether it's for building your emergency fund, setting aside money to invest or saving up for a big purchase or vacation.
If you follow these guidelines, you should still have enough left for other expenses. It's a handy way to make sure your salary matches your expenses and keeps you in the black each month.
Rule 2: Buy and Hold
It may be tempting in a market like the one we've had lately to try to time your buying and selling to capitalize on stock market upswings and downturns. But countless investment professionals have proven the wisdom of buying and holding stocks for the long haul -- that could mean 3 years, 10 years or more. The logic behind buying and holding is that stocks have historically risen about 10 percent a year on average. So by buying a stock or stock-based mutual fund and holding it for, say, 10 years, you'll be protected from losses if the market edges down for 2 years in a row and then climbs for 2 years after that.
On average, you'll have made money by just staying in the game, rather than trying to time a buy with a big dip in a stock's price or trying to predict its high before selling. None of us are that good when it comes to forecasting the future, so buying and holding is the surest way to make money consistently over the long run.
Rule 3: Diversify
This is another rule that is particularly important in changing financial markets: The more diversified your investments, the better you'll be able to weather downturns that strike specific investment categories.
The rule of thumb for young investors is to keep about half of your investments in stocks or stock mutual funds, 30 percent in bonds or bond funds and 20 percent in cash or cash equivalents such as CDs or money market accounts. More aggressive young investors are often advised to keep as much as 80 percent in stocks or stock funds, but if you choose to do this, stay diversified by investing in several categories of stocks or funds, including things like blue chip companies, technology stocks or funds, international companies, food stocks and smaller emerging companies. This will give you downside protection if any one of these categories goes through rough times. If stocks are down, cash or equivalents might be up. So you'll be protected.
Another way to diversify is by investing in mutual funds rather than buying individual stocks or bonds. Mutual funds are by nature diversified since they contain stocks or bonds of many different companies, protecting you against a bad performance by just one stock or bond. But you can diversify further by investing in several different mutual funds.
Rule 4: Use the Rule of 72 to Save
The rule of 72 is a handy way to estimate how your money can grow at different interest rates. It can help you line up your savings goals with actual results you can achieve. The rule of 72 helps you calculate how long it will take your money to double. Here's how it works: Divide 72 by the interest rate (or rate of return) you're getting on your money. That's how many years it will take you to double it. For example, if you're earning 6 percent in a CD account, it will take you 12 years to double it (72/6 = 12).
Use this rule to help meet your savings goals. If you know you need to save $8,000 and you're starting with $4,000, you can use the rule of 72 to figure out how long it will take you at different interest rates. If you're considering a 4 percent CD account that requires you to lock up your money for 3 months or an 8 percent CD that requires you to lock it up for 3 years, which should you choose? Using the rule of 72, you'll see that it will take you 9 years to turn $4,000 into $8,000 at 8 percent interest, so locking it up for 3 years at a time will be no problem. At 4 percent, it would take you 18 years to double your money, so having access to it after 3 months won't do you much good. You'd be better off going with the higher interest rate and the 3-year lock.
Rule 5: Manage your Debt
There's no question that debts can be a slippery slope. No matter how much you seem to pay each month, they can linger and accumulate interest. But in order to keep your debts from taking over your financial life, you should try to keep them at a consistent level rather than letting them grow out of control.
First, try to keep your debt at a level that is no more than 20 percent of your take-home pay. When calculating how much debt you have, include ongoing credit card bills, student loans and lines of credit. If your debt is higher than 20 percent, check out loan consolidation programs to try to put all your loans into one loan at a lower interest rate. Or simply call your credit card company and see if you're eligible for a rate reduction. Sometimes all you have to do is ask. For more information on decreasing your debt, click here.