Is the "10% Rule" The Best Way to save Money?
What Financial Gurus & Economists Get Wrong about Saving Money
“All models are wrong, but some are useful.”
—George E.P Box
Welcome to the first entry in the “Calling Financial Bull$hit” series.
Here’s what to expect in this series going forward.
In each post, I will look at particular personal finance topics and review what the research says is the optimal way to make decisions compare that to trending advice, and make a determination if popular personal finance advice you read online is Bull$hit, legit, or somewhere in between.
The goal of the series is to help you make better financial decisions and avoid getting scammed.
To be clear, not all popular financial advice is Bull$hit, and not everything economists say about the “Rational” approach to personal finance works in the real world.
I feel uniquely suited for the task of weighing the advice of personal finance gurus and economists, as I have spent my entire adult life in the world of economic research while moonlighting as a personal finance author. I have a foot planted firmly in each camp.
Today’s topic is how much money you should save and how much you should spend.
Here’s what the economists say about “optimal saving and consumption”
The lifecycle model is an economic model that describes the optimal amount of saving and spending at different phases of a person's life to maximize lifetime happiness.
A simplified summary of the lifecycle model is that people should spend a lot and save a small percentage of their income when they are young, and their income is low. In fact, according to the lifecycle model, young people should borrow money when they are young and pay it back when their income is higher in the future.
This is how it plays out in reality; young people borrow money to pay for their education and buy a house, and then as they get older—and their income increases—they pay those debts down and (in theory) also save for retirement without having to sacrifice their lifestyle.
The lifecycle model is all about “consumption smoothing,” which means maintaining your desired lifestyle at each phase of your life.
So, according to economists, your goal is to keep a constant level of spending throughout your life and put off saving until your peak earning years.
The FIRE Movement is the exact opposite of the lifecycle model
The Financial Independence, Retire Early (FIRE) movement is on the opposite end of the spectrum.
Where the economists say you shouldn’t worry about while you’re young, the FIRE movement preachers extreme frugality in your younger years to achieve extreme savings rates (50%+) to stop working as quickly as possible.
I have pointed out in the past that the FIRE movement is a response to unfulfilling jobs. Some people hate their job so much that they would gladly spend their 20s and 30s penny-pinching for the promise of being able to “retire early.”
But here’s the thing, you don’t need to “retire” to leave a job you hate. You can quit that job and find one you like better.
A much more rational approach—and one that is perfectly in line with the life cycle model—would be simply to find a job you like, even if it pays less.
Who is living a better life; the person working a job they hate making $70,000 per year and living off $25,000 to shave a few years off their work life or the person making $60,000 and spending $50,000 per year doing work they enjoy while being able to fund a traditional retirement?
I talk about that in my first book, The Financial Freedom Equation, which provides an alternative to the FIRE movement: where you align your finance to pursue work you enjoy, even if it means taking a pay cut.
The FIRE movement is Financial Bull$hit
The 10% Rule
Personal finance bloggers love simple savings rules.
The classic simple saving rule is to save 10% of your income, regardless of your age. This also flies in the face of the lifecycle model, which advocates saving nothing when you’re young and saving much more than 10% in your 40s and 50s.
While 10% is an arbitrary number that will not guarantee you reach your financial goals, this is as good a time as any for me to criticize the lifecycle model.
With the exception of the field of behavioral economics— economists fail miserably at understanding or even acknowledging the existence of human psychology.
Economists are a strange group of people who make models with the assumption that people are robots and not, well, people. Economists can program the robots in their models to make decisions that will “maximize lifetime utility,” which nobody does in real life.
On the other hand, the most popular personal finance gurus understand what motivates people, and it is one of the reasons why people are more likely to listen to a TikTok star (who knows nothing) than an economist (who understands financial markets.)
So, while adopting a simple rule like “always save 10% of your income” is almost always the suboptimal choice, it’s advice that is so simple that everyone can understand it, and some people will actually follow through on it—which is more than I can say about the lifecycle model.
Imagine a 21-year-old being told to manage their finances according to the lifecycle model. They are told to save nothing in their 20s and early 30s, and suddenly on their 35th birthday, they are expected to flip an invisible mental switch and instantly become a super saver.
People are creatures of habit, and if you spend your entire adult life with the habit of saving nothing, it will be very difficult to break that habit later in life.
While saving an arbitrary amount of your income is not “optimal,” it acknowledges the reality of human psychology and creates a habit of saving and investing. Creating a saving habit is more important than finding the optimal savings rate early in your career.
Investing even small amounts of your money when you are young is also a great way to learn about investing with the training wheels on.
Learning the importance of not panicking during a market crash is a lesson I would much rather learn at age 24 with $5,000 invested and 40 years to retirement than at age 52 with $500,000 invested and a decade to retirement.
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A few final critiques of the “Rational approach” and parting thoughts
I can’t wrap up this article without mentioning a few more of the assumptions that the lifecycle model makes that ignore the reality of real life.
First, it assumes that your income follows a linear relationship with age. Every year you get older, you will earn a little bit more income until you retire. In reality, people’s incomes are up and down throughout their lives due to promotions, getting fired, starting a business, having a business fail, etc. Furthermore, more and more people continue working part-time in retirement, a reality that the lifecycle model ignores.
Second, it assumes that everyone aims to spend their last dollar on the day they die.
Putting aside the difficulties of executing a “Die with nothing” plan, the real problem is that not everyone has that goal. Economists look at people as “consumers,” which means the goal of the lifecycle model is to maintain a constant level of consumption and die with nothing.
Some people may have this goal. But for others (myself included), a large part of their identity is that they see themselves as providers and protectors. My long-term goal with money is the opposite of “dying with nothing,” It’s to leave enough money behind to sustain my kids and any kids they might have—to make their lives easier, even if that means making sacrifices and foregoing my “optimal level of lifetime consumption.”
So, what is the “Right” amount to save and spend throughout your life? At this point, it should be obvious that there is no “right” answer to that question.
I can’t believe I am writing these words, but I think the 10% savings rule is the closest thing to a good answer here. It’s simple and achievable and can be pretty flexible if you accept there is nothing magical about 10%.
Younger people may be best served to start with a small amount of savings (less than 10%) and could adjust their savings rate as their income allows in the future. This splits the difference between the advice economists, and personal finance gurus would give about saving money.
What’s the best advice about saving money that you were able to stick with? Let me know in the comments.
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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.
Another great post. I love reading your work over my morning coffee whenever you post.
As I start thinking more seriously about what to leave for my kids when I "pop" off (hopefully many many years from now), I spend more time wondering how to find the right balance between making life easier for them and helping them learn the value of money and hard work. Don't want them to grow up with a sense of entitlement. I worked hard to get to where I am. That said, I cannot hold a candle to my father's struggles - he started working to support his family (mother and two sisters) from the age of 15. Similar life stories on my wife's and in-laws' side - lots of hard work, simple lives and sweat equity to raise their family.
We have amazing, kind, generous kids...but they have no real-life sense of what it took for us or their grand parents (on both sides) to build a home and comfortable life.
Maybe I am over-thinking this. I am sure they will have their own life challenges along the way as they go through adulthood. As long as each generation makes life easier for the next..that is probably the best roadmap for life.
Cheers and enjoy your weekend!
A much more rational approach—and one that is perfectly in line with the life cycle model—would be simply to find a job you like, even if it pays less.
I like that view