financial rules of thumb


Rules of thumb – those little pieces of wisdom intended to help you with everyday life – can save you some time. For instance, the rule of 72 – dividing 72 by an annual rate of return can help you estimate how long it takes an investment to double. It’s faster than plugging numbers into your calculator app and provides a decent estimate. On the other hand, following or trying to follow some financial rules of thumb can hurt your financial situation.   

definition of rule of thumbYears ago, financial folk wisdom said you couldn’t go wrong with real estate. The theory was that there was limited supply and that demand for real estate would grow as the population grew. Since the events leading up to the financial collapse in 2008, it has been clear that real estate is not always a winning investment. 

Intended audience 

It’s important to remember the intended audience when evaluating these little nuggets of wisdom. The rules are devised to be general and easy to remember. They will apply to a broad range of people. However, they won’t always be the best advice for everyone. If you are going to research to determine if a rule applies to you, you might as well research to determine what is best for you. As we’ve discussed in our financial myths series, you are not average. 

A little context 

It’s essential to keep these rules in context and remember the context that brought them about. You can look at our current economic situation at any given time and say it is unusual due to some specific circumstance. Right now, you could point to interest rates that have been at historically low levels for an extended time. Or you could refer to the current unemployment rate. If you are living on fixed-income investments, quick guidelines about appropriate withdrawal rates or expected income might not apply – especially if they were conceived with higher average interest rates in mind. Or perhaps you are determining how much you should have in emergency savings in case of an involuntary separation from your job. An unusual trend in the unemployment rate could indicate how difficult it will be to find a new position. Current economic circumstances should figure more prominently in your decision than a rule of thumb. 

A little caution – where you can get in trouble 

Here are a few often-cited rules that can get you into trouble. The age-and-stock rule is one adage that makes us cringe. The rule says that you should have 100 – your age as the percentage of your portfolio held in stocks. We appreciate that the rule’s intended purpose is to remind investors to adjust their portfolios over time. However, there is also the assumption that a younger investor has time to recover from the greater volatility that stocks often experience compared to bonds. This may be the case for retirement savings for people who intend to work full-time until age 65 or so. But it doesn’t consider people saving and investing for other purposes such as education funding. And it doesn’t take into account the possibility of early retirement. Probably more important than the time horizon issues, it doesn’t consider individual risk tolerance. Based on this adage, a risk-averse 30-year-old may invest 70% of his portfolio in stocks. That could be a problem if the market becomes particularly volatile. Investors are more likely to sell at inopportune times and incur losses if they simply can’t tolerate the risk or volatility in their portfolios. An investor should consider his time horizon and risk tolerance when determining an appropriate portfolio allocation. 

Times change 

Other rules of thumb have stuck around in spite of changes in the environment. For instance, the belief that ‘it is always best to pay tomorrow rather than today’ is based on some broad assumptions. It seems simple: holding on to your money longer is better, especially when it comes to paying taxes. It’s rarely that simple, though. There are always new and changing elements to consider. For instance, when deciding between traditional 401k and Roth 401k or traditional IRA and Roth IRA contributions, many people were confident that they would be in lower tax brackets when they retired and that they would save on taxes. Yet now, regardless of whether they believe tax rates will be higher or lower when they retire, they cling to the idea that it is always better to defer taxes. Economic conditions have changed such that people have different expectations about their future situations, but they forget to adjust their financial rules of thumb. 

More than meets the eye

raccoon - rule of thumb

Many of these “common sense” financial rules of thumb work only in very narrow situations. For instance, returning to the question of deferring taxes above, a difference in tax rates is only part of the picture. Tax rules regarding minimum distributions require taxpayers to withdraw certain percentages of their 401k and IRA accounts when they reach age 70 ½. They must do this whether or not they need or want the income at that time. In some cases, increased income from their retirement accounts (the Required Minimum Distribution or RMD) can actually cause a larger portion of their social security income to be taxable. And in some of these cases, the increased income can also trigger an increase in their Medicare premium. Relying on this (or any) financial rule of thumb without considering other factors can produce unintended consequences – like paying more in taxes and Medicare premiums by deferring taxes on their retirement contributions. 

They have their place 

Some financial rules of thumb have their place. For young people starting out, they may serve as reminders that establishing emergency funds, participating in employer retirement plans, and saving (pay yourself first) are essential to building a strong financial base. Quick-and-dirty estimates from the rule of 72 or the rule that says “double your hourly wage and multiply by 1000 to estimate your annual income” can be helpful. However, it is essential to understand what assumptions are involved to determine if using the rule is appropriate in your situation. For instance, the rule regarding the conversion from hourly wage to annual income is based on working 40 hours a week for 50 weeks of the year. And the rule of 72 works best at low rates of return. At higher rates of return, the result is less precise. 

It comes down to priorities 

How important are your financial goals to you? Are they important enough to research appropriate strategies rather than relying on sayings from long-forgotten sources? Align your efforts with your goals. If retiring comfortably is important to you, then be sure to understand the available options for saving and investing for retirement. If paying for college is important to you, then make sure to understand the current landscape of options for saving for and paying for college. And, if you aren’t confident about your plans to reach your financial goals, seek advice specific to your situation. As you learn more about the options available and the best ones for your financial situation, maybe you’ll devise your own financial rule of thumb to track your progress toward your goals. 

Interested in reading more about some of the most common financial myths? Check out our financial myth series, including Myth: It’s Always Better to Buy than Rent, Myth: It’s Always Better to Defer Taxes and Myth: It’s Always Better to Pay Down Debt As Fast As Possible.

This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. We examine these factors and many others during our financial planning process to determine appropriate financial strategies for YOU.

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