Everyone loves a good rule of thumb. Knowing that the number of cricket chirps in 15 seconds plus 37 is the approximate temperature [1] is great . I usually do the old 100 plus my age comparison when I get my blood pressure checked as well. These ballpark estimates are easy to remember and give a close enough approximation for many things in life. Unfortunately, there are often way too many variables for a rule of thumb to be of any real value for personal finances.
There are some financial rules that are valuable, but they tend to be the ones that are math based. An example would be “Double your hourly rate and add three zeros to get approximate yearly salary.” Of course, even such a rule makes the assumption that you work 40 hours per week. These “rules of thumb” are what I generally file under Quick Calculations. They are more mathematical approximations than true rules of thumb, so they are generally relevant for most people.
The other type of financial rules of thumb are the ones that I dislike. A typical example might be that 120 minus your age is the percentage of your portfolio that should be in stocks. The problem, as stated above, is that there are too many variables. I doubt that proper portfolio allocation follows such a simplistic, linear approximation. Some of the critical factors not accounted for by this simple rule are: desired retirement age, life expectancy, other income sources, standard of living, non-investment savings, and geographic location, just to name a few. Clearly each of those factors could seriously alter your optimal portfolio allocation. Looking at just one of those examples, you can imagine how differently someone hoping to retire at 40 would invest compared to someone resigned to work until age 70. The 120 minus your age rule is much too simple to handle so many variables. Many financial rules of thumb have the same shortcomings.
Financial plans are highly personal and influenced by many factors in our lives. Using a rule of thumb is fine for estimating the temperature because if you get a poor estimate it probably won’t do much damage. Using a poor estimate as the basis for something as critical as your personal finances can be disastrous. So take a little extra time and take your personal situation into consideration for all financial planning decisions.
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March 18th, 2008 at 6:46 am
Carnival of Everything Finance - #15…
Carnival of Everything Finance - #15
Welcome to the March 17, 2008 edition of Carnival of Everything Finance.
We had over 110 really good articles submitted for this edition. Unfortunately I could not include all of them.
I hope you enjoy read…..
March 21st, 2008 at 2:29 am
Here is another financial rule of thumb: The rule of 72.
Take the number 72 and divide it by the current interest rate that you are earning for one of your accounts. This is the approximate number of years it will take for those funds to double.
Lets say you are earning 8%/year on an investment. 72/8=9. Therefore it will take 9 years for those funds to double in value.
So how about everyone who is content earning .5% in their savings account…72/.5=144. It will take 144 years for the funds in your regular savings account to double! I can’t think of a better reason to convince someone to invest their money.
March 21st, 2008 at 7:11 am
DP: I couldn’t agree more with your analysis of savings accounts. Even direct banking rates (which are typically much higher than “traditional” savings accounts) have been coming way down as a result of all of the recent Fed cuts. It may have been somewhat difficult to beat the 5%+ guaranteed returns they used to offer, but beating the current rates, which are closer to 3%, is much easier.