Managing money can feel overwhelming.
Saving money, paying off debt, tracking your bill payments, saving for retirement, and investing strategies. There is a lot to keep track of, and we all have more pressing things to worry about, like our family and our careers.
The idea of a “Shortcut” to simplify money management is appealing to nearly everyone.
We have “shortcuts” or rules of thumb that intend to simplify personal finance. Not all rules of thumb are created equal, and even the best rules of thumb have limitations.
This is a two part-guide to using financial rules of thumb. I don’t normally break a topic into multiple posts, but this post ended up being way too long, and I didn’t want to cut valuable info for the sake of word count.
Rules of thumb associated with financial well-being
In 2020, Morningstar surveyed 867 people and studied how their use of financial rules of thumb impacted their financial well-being.
This is fascinating as this is the first research study I have found that aims to pair the use of rules of thumb with financial well-being. They measured the use of rules of thumb across four personal finance categories.
What I find slightly disappointing about the study is how basic the rules of thumb they asked about were.
Here is the rule of thumb that was most correlated with financial well-being in each of the four categories.
Saving—> “separate savings accounts from spending accounts.”
Spending—> “Don’t spend more than you make.”
Investing—> “Start as early as possible.”
Debt Management—> “always pay your debt in full.”
On the one hand, I look at this list, and I think if everyone simply followed through on these four rules of thumb, we would all be a lot wealthier.
On the other hand, these aren’t really what I think of when I think of a “rule of thumb.”
To me, a rule of thumb should help guide your actions.
For instance, take “Start investing as soon as possible.” That’s nice, but a more useful rule of thumb would give you an idea of how much you should invest depending on when you start and what your goals are.
Other popular rules of thumb
Here are seven popular rules of thumb you may have heard of before.
The 4% rule and 25 times rule (retirement savings)
The rule of 110 (investing)
The 36% rule (debt management)
The 1% rule (real estate investing)
The 1% rule (homeownership maintenance costs)
The 30% Rule (housing costs)
The 5% rule (buy vs rent)
I’ll discuss how to use each of these rules of thumb and highlight each of their assumptions and limitations. As we highlight the flaws, I’ll discuss whether each rule of thumb can be modified to be more useful or whether it should be discarded entirely.
What all of these rules of thumb have in common is that they force you to think about an important financial topic. Even if a rule of thumb does not give you the answer, it can act as a crucial first step in obtaining the answer.
Let’s get into it.
#1—The 4% rule and 25 times rule (Retirement savings)
The 4% and 25 times rule are two sides of the same coin that help answer two important retirement questions.
How much do I need to save to retire?
How much money can I spend in retirement?
The 25 times rule states that once you have saved up 25 times your annual living expenses, you have enough money to retire.
The 4% rule states that you can withdraw 4% of your retirement nest egg to fund your first year of retirement. In the following years, you increase how much you withdraw by the rate of inflation.
You might notice the mathematical similarities between the 25 times rule and the 4% rule, 4%=1÷25.
An example of the 25 times and 4% rules
Let’s say your projected annual living expenses in retirement were $40,000.
Using the 25 times rule, you estimate you would need $1 million ($40,000 times 25) to retire.
Using the 4% rule, you estimate you could withdraw $40,000 (4% of $1 million) in your first year of retirement.
For the rest of your retirement, you increase your withdrawals by the rate of inflation. If inflation was 2%, then in year two of retirement, you would withdraw $40,800 from your retirement nest egg.
Assumptions & limitations of the 25 times and 4% rules
Like any rule of thumb, the 4% and 25 times rules are an oversimplification of a complex issue and fails to address many of the very real problems. Here are a few of the assumptions and limitations of the 4% rule.
It’s not a flexible plan. The 4% rule advocates you increase your spending each year by the rate of inflation regardless of what is happening in the economy or financial markets. It fails to deal with questions like what if inflation is 8%? What if the market goes down 50%?
It’s modeled using a 50/50 portfolio of U.S stocks and bonds. That is a very specific asset allocation that does not include global diversification.
It relies on historical U.S market returns. Past returns do not imply future returns. At the time I write this, interest rates are historically low, which means expected future stock and bond returns are lower than in the past.
It assumes a 30-year retirement. The 4% rule fails to answer questions like what happens if you retire at 65 and live to be a 120?
It ignores taxes and investment fees. This is a perfect example of how a plan can look better in a spreadsheet than in real life.
#2—The rule of 110 (investing)
The rule of 110 is a rule of thumb that states that the amount of your portfolio you allocate to risky investments like stocks should be equal to 110 minus your current age.
A 20-year old using the rule of 110 would have a portfolio of 90% stocks and 10% bonds.
A 60-year old using the rule of 100 would have a portfolio of 50% stocks and 50% bonds.
The basic premise behind the rule of 110 is that younger investors can more easily take risks compared to older investors.
If you are decades away from retirement, you have a long time to recover if the stock market goes in the tank.
On the other hand, if you are in retirement and too much of your portfolio is in stocks, a market crash could be devastating to your retirement plans.
Why I don’t like the rule of 110
Every rule of thumb makes a trade-off between simplicity and accuracy. Sometimes, that trade-off is tolerable, especially if there are simple modifications that can be made to the rule of thumb.
The rule of 110 is too simplistic and only considers one factor, the investor’s age. While the investor’s age is an essential factor to consider when choosing an asset allocation, other important factors must also be considered.
Other assets and streams of income.
Determining your asset allocation is too important of a decision to be determined simply by your age.
A simple alternative to the rule of 110
Rather than use the rule of 110, why not take all relevant factors into account when deciding on your asset allocation. Vanguard has created a simple questionnaire to help you determine how much of your portfolio should be allocated to risky assets like stocks and lower-risk assets like bonds.
In chapter 6 of the rational investor, I offer a different perspective on how much in risky vs. safe assets. It comes down to balancing your human capital and financial capital.
A paycheck is like receiving a bond payment, and young people have a lot of paychecks left to collect, so they should have more stocks to balance out their total portfolio.
The rational investor is only available to paid subscribers, but here is a 7-day free trial if you want to get started.
#3—The 36% rule (debt management)
The 36% rule states that your total debt payments shouldn’t be more than 36% of your pre-tax income.
If you make $10,000 per month before taxes, your monthly debt servicing costs shouldn’t exceed more than $3,600.
That would include your mortgage (if you have one), credit cards, car payments, or any other type of debt.
There’s nothing magic about 36%. If you spend 40% of your income on debt, that doesn’t mean you’re heading for the poorhouse. It’s also not a license to wrack up more credit card debt if you’re below 36%.
Ideally, you’ll aim to pay your debts off over time, and eventually, you’d spend 0% of your income on servicing debt.
If nothing else, the 36% rule forces you to ask, “how much of my income do I spend on servicing debt?”
Do you know your answer?
If not, your homework assignment is to round up all your monthly statements and divide your total debt payments by your pre-tax income.
Like the rules of thumb we’ve been discussing, I’ve picked this to be the arbitrary but useful point to hit pause on our discussion on rules of thumb. Stay tuned. Next Friday, I will release part two of our discussion.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.