What is a Rule of Thumb?
A rule of thumb is a heuristic guideline that provides simplified advice or some basic rule-set regarding a particular subject or course of action. It is a general principle that gives practical instructions for accomplishing or approaching a certain task. Typically, rules of thumb develop as a result of practice and experience rather than through scientific research or a theoretical foundation.
Key Takeaways
- A rule of thumb is an informal piece of practical advice providing simplified rules that apply in most situations.
- There are many rules of thumb in finance that give guidance on how much to save, how much to pay for a house, where to invest, and so on.
- Rules of thumb are not scientific and do not take into account the individual circumstances and needs of a person, so they may not be applicable to your particular situation.
Embrace the Wisdom of Rules of Thumb
Investors often benefit from a variety of “financial rules of thumb” designed to help individuals learn, remember, and apply financial guidelines. These principles offer streamlined methods and procedures for saving, investing, purchasing a home, and planning for retirement. While a rule of thumb may be broadly suitable, it may not be universally applicable to every individual and their unique circumstances.
The Rule of 72 is one such quick, useful formula that is commonly used to estimate the number of years required to double the invested money at a given annual rate of return. While calculators and spreadsheets have inbuilt functions to accurately calculate the precise time required to double the invested money, the Rule of 72 serves well for mental calculations to quickly gauge an approximate value.
Inspiring Examples of Financial Rules of Thumb
There are several well-known financial rules of thumb that provide guidance for investors, including the following guidelines:
- A home purchase should cost no more than two and a half times your annual income.
- Save at least 10-15% of your take-home income for retirement.
- Ensure you have at least five times your gross salary in life insurance death benefit.
- Pay off your highest-interest credit cards first.
- The stock market has a long-term average return of 10%.
- Maintain an emergency fund equal to six months’ worth of household expenses.
- Your age should represent the percentage of bonds in your portfolio.
- Subtract your age from 100 to determine the percentage of stocks in your portfolio.
- A balanced portfolio typically consists of 60% stocks and 40% bonds.
Additionally, there are rules of thumb for estimating how much net worth you will need to retire comfortably at a typical retirement age. Here’s a general calculation to determine your net worth:
- If you are employed and earning income: ((your age) x (annual household income)) / 10.
- If you are not earning income or you are a student: ((your age - 27) x (annual household income)) / 10.
Proceed with Caution: Take Rules of Thumb with a Grain of Salt
While rules of thumb provide useful general guidelines, they can be overly simplistic in many situations, potentially leading to underestimation or overestimation of an individual’s needs. Rules of thumb do not factor in specific circumstances or changes over time, which should be carefully considered for making sound financial decisions.
For instance, in a tight job market, an emergency fund amounting to six months of household expenses may not consider the possibility of extended unemployment. Likewise, buying life insurance based on a multiple of income does not address the specific needs of the surviving family, such as the mortgage, the need for college funding, and extended survivor income for a non-working spouse.
Related Terms: heuristic, finance rules, financial advice, investment strategies.
