Do you have any favorite financial rules of thumb? I recently ran across an interesting study in which the researchers looked at the impact of formal financial training vs. simplified, rule-of-thumb training on financial decision making.
While the focus of the study was rather narrow (micro-entrepreneurs in the Dominican Republic), the results were quite interesting. In short, they found that “standard” financial training had no impact on business practices and outcomes, but that simplified, rule-of-thumb based training produced “significant and economically meaningful improvements.”
While it’s probably a stretch to take lessons from micro-entrepreneurs in the Dominican Republic and apply them to your family’s budget, I’d be willing to be that there’s some truth to the idea that it pays to keep things simple.
For example, instead of teaching people how to calculate their needs income needs in retirement and how to project their exactly what it will take to get there, simply telling them to save and invest 10% (or 15% or 20%, whatever) for the future.
Likewise, instead of teaching people about modern portfolio theory and the importance of asset allocation, maybe we should just tell them that their percentage stock allocation should be 100 minus their age.
Of course, rules such as these aren’t failsafe, nor should we expect them to be. After all, a rule of thumb is defined as:
…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.Source: Wikipedia
Beyond the inherent limitations of a one-size-fits-all rule, it’s also important to recognize that these rules can change over time. While sometimes these changes are warranted, other times they may not be. For example…
The old “100 minus your age” advice, mentioned above, eventually morphed into “120 minus your age” when modern pundits got their hands on it during the high-flying markets of a decade ago. To be fair, this change was also likely influenced by longer life expectancies, but still… How does that change look in the context of the past three years?
Similarly, the age old advice of spending no more than 28% of your monthly income on your mortgage payment gradually swelled to 30%, then 33%, and finally 36% as housing prices spiraled out of control. Once again, how does that change look in the context of the recent history of the housing market?
But in the end… If preaching rules of thumb spurs people to action – as opposed to overwhelming them into inaction – then maybe that’s where our focus should be.
What are your favorite financial rules?
11 Responses to “Financial Rules of Thumb: The Value of Keeping it Simple”
“Pay something to those you owe before yourself.”
I know that’s somewhat controversial (with those “pay yourself first” folks) & true sending $10 or $20 to the mortgage company out of Christmas bonus is financially negligible, but more about the behavioral change. I can be “bi-polar” financially, going from hoarder to spendthrift also I started to get myself in trouble in the 1990’s, but this was in the day of Larry Burkett instead of Dave Ramsey – more “Do not borrow money without a plan to repay” and reminder that the debtor is a slave to the creditor but not the absolutes [thus no dramatic credit card burnings]. That helped me and how I’m knitted together, a simple rubric first fruits give, then pay on any money that not mine then me. Oddly, now I do save and any balance run up is smaller, because I didn’t do away with my ability to leverage my purchasing power but did change the way I thought about it.
my favorite one is: “If your company offers a match on retirement, ALWAYS save up to the match”. That’s one place that I disagree with some financial gurus (cough*DaveRamsey*cough). I didn’t ever contribute less than the full match, even when paying down debt. I don’t leave money on the table. Ever.
My favorite rule of thumb is “keep your fixed costs at or below half your take home” (or “Pay your rent with your first check” when my life was simpler.)
It turns out being very close to the 50% needs/30% wants/20% savings division I’ve been seeing around lately – a little bit more conservative, but I’m pretty cautious with money in general.
My most important rule is stick to reality, not what I hope or want it to be.
This applies to investing, saving, spending, and everything else! Sometimes you want that stock to make it to a 50% return, but you know that 25% is good, and maybe you should sell…
Leen: Interesting, I hadn’t heard that. However, a bit of Googling reveals that this (the wife beating angle) may not actually be the true origin of the phrase.
For example, here and here. I realize that neither of these is particularly authoritative, but then again neither are the sites that I’ve found claiming that the term had its origin in wife beating.
Edit to add: See this Wikipedia page on folk etymology, in the subsection under “urban legends.”
Setting that aside, I’ve seen that guideline from All Your Worth, and I think it makes a lot of sense.
I always just look at a non-essential purchase and ask myself if I would borrow money at the highest interest rate I am currently paying to have it now instead of later. If you have a 20% credit card that will take a year to pay off, everything you buy has an instant 20% markup until you pay off that debt.
Not to open a can of worms, but “rule of thumb” is a horrible phrase for me because it originated as a real rule – a man was allowed to beat his wife with a stick as long as it didn’t have a diameter thicker than his thumb. Financial Guidelines would work just as well. My guideline is from the book All Your Worth – needs 50% Savings 30% Wants 20% (I switch savings and wants) of your money.
The “Rule of 72”
The “Rule of 72” is a simplified way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return, you can get a rough estimate of how many years it will take for the initial investment to duplicate itself.
For example, the rule of 72 states that $1 invested at 10% would take 7.2 years ((72/10) = 7.2) to turn into $2. In reality, a 10% investment will take 7.3 years to double, so you can see that the Rule of 72 provides a pretty good rule of thumb.
BG: Yep, that’s another way of saying 100 minus age should be stocks (assuming stocks and bonds are the only two options). Thanks.
Bond allocation percentage should be equal to your age.
My number one rule of thumb – Do I understand what I am about to do with my money? I always ask this question, when it comes to investments, debt reduction, making a donation, etc. Put another way – Be INFORMED.