What is a Rule Of Thumb?
Let me explain what a rule of thumb really is. It's a heuristic guideline that gives you simplified advice or a basic set of rules for a particular subject or action. Think of it as a general principle offering practical instructions to accomplish or approach a task. These rules typically come from practice and experience, not from scientific research or theoretical foundations.
Key Takeaways
You should know that a rule of thumb is an informal piece of practical advice that provides simplified rules applicable in most situations. In finance, there are many such rules guiding how much to save, what to pay for a house, where to invest, and more. Remember, these aren't scientific; they don't consider your individual circumstances and needs, so they might not apply to your specific situation.
Understanding Rules Of Thumb
If you're an investor, you've likely encountered various 'financial rules of thumb' designed to help you learn, remember, and apply financial guidelines. These address saving, investing, buying a home, and planning for retirement. While a rule of thumb might suit a broad audience, it doesn't apply universally to every individual and their unique circumstances.
Take the Rule of 72, for instance—it's a quick, useful formula to estimate the years needed to double your invested money at a given annual return rate. Sure, calculators and spreadsheets can give precise calculations, but the Rule of 72 is great for mental math to get a rough approximation.
Examples of Financial Rules of Thumb
There are several well-known financial rules of thumb that guide investors. For example, a home purchase should cost less than two and a half years of your annual income. You should save at least 10-15% of your take-home income for retirement. Aim to 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%. Keep an emergency fund equal to six months' worth of household expenses. Your age can represent the percentage of bonds in your portfolio, or subtract your age from 100 for the percentage of stocks. A balanced portfolio is typically 60% stocks and 40% bonds.
Calculating Net Worth for Retirement
There are also rules of thumb for figuring out how much net worth you'll need to retire comfortably at a normal age. Here's the calculation I use: If you're employed and earning income, it's (your age x annual household income) / 10. If you're not earning or you're a student, adjust it to (your age – 27) x (annual household income) / 10.
Take Rules of Thumb With a Grain of Salt
While these rules are useful as general guidelines, they can be too oversimplified in many cases, leading you to underestimate or overestimate your needs. They don't account for your specific circumstances or factors that might change over time, which you must consider for sound financial decisions.
For instance, in a tight job market, an emergency fund of six months' expenses doesn't factor in extended unemployment. Similarly, basing life insurance on a multiple of income ignores the surviving family's specific needs, like a mortgage, college funding, or income for a non-working spouse.
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