“As a rule of thumb, you probably shouldn’t be taking a nap now since it’s a workday,” my daughter told me the other day. And she’s right. She told me on a Monday too. Plus, I was being lazy all morning. All in all, it’s been a fantastic start to the week.
Don’t Rely Too Much on Financial Rules of Thumb If You Care About Your Sanity
But what good would it do for me to just sit in front of the computer staring at my computer screen? Wouldn’t it be better for me to take a nap, feel energized afterward and be more productive? “I’ll take a nap now and figure out a way to make money off of this” and off I went.
Are Rules of Thumb Ruling Your Financial Life?
If you keep up with financial news and information, one thing you know is that there are many rules of thumb related to your money. From deciding how much money is needed from your retirement account as you get older to figuring out how much life insurance coverage is necessary to how much home you can afford, there are rules of thumb designed to give you guidance.
Unfortunately, rules of thumb are a bit general. They don’t account for your individual circumstance, and you might find that your favorite rule of thumb doesn’t really reflect your current needs – or current market conditions. If you spend your whole life following all the rules of thumb to the tee, it might make you save too little or work too long.
The Problems with Rules of Thumb
The biggest problem with any rule of thumb is the fact that it’s general and not specific to your situation. At the end of the day, your situation isn’t just like everyone else’s. Take life insurance for example. Many people say that you should take your annual salary and multiply it by 10 to get the amount of life insurance you should purchase. However, this doesn’t take into account how many dependents you have, or what you hope to accomplish with the payout if you pass on in an untimely manner. Instead, factors like how much debt you have, whether you want to pay for your kids’ college educations, or whether your significant other works matter. For some people, 10 times salary in coverage won’t be enough, while it’s way too much for others.
Another issue with rules of thumb is that they can be confusing. Many think that in the current climate, the 4% withdrawal rule of thumb for retirement accounts is clear as mud. This rule of thumb says that you should be able to withdraw 4% of your account balance each year and increase it with inflation without running out of money for a 30-year retirement. This translates to needing 25 times your expenses saved by the time you retire.
But with bonds returning less than the historical average and stocks at a high valuation, some experts are now saying that 2.5% is more likely to be the sustainable withdrawal rate going forward. This is easy for academics to say, but taking 2.5% out rather than 4% means that instead of needing to save 25 times expenses, you now need to have 40 times your projected expenses saved up. That’s like asking you to all of a sudden have 58% more in your nest egg. You don’t just flip on a switch to make this happen.
On the other hand, Fidelity is one of the largest asset managers in the world with close to 10 trillion in total customer assets and their rule of thumb for their customers is to have 10 times income saved. Now, I know income and expenses are two totally different metrics to use but 10 times versus 40 times? That’s a gigantic difference. In the real world, you are talking about someone who’s been frugal all her life and invests in all the right investments versus someone who mostly lives it up and just has mediocre investment performance.
Which rule of thumb do you follow? I know which one I want to trust, but which one is the better choice?
Use Rules of Thumb as Starting Points
Rather than using a rule of thumb as the last word on your financial situation, use it as the starting point. Buying a home is a good example. The rule of thumb is that you should spend about 30% of your income on home payments. But what if you have a variable income? Perhaps committing such a large chunk to your home payment isn’t wise just in case you have a few down months. For you, it might be more appropriate to limit your mortgage payment to 20% of your income.
This approach works for retirement, saving for a rainy day, and for other situations too. A rule of thumb can give you a general idea of how to proceed, but don’t rely on it entirely. Instead, tweak the situation so that what you do matches your needs. Don’t be afraid to break the rules.
Once I woke up, I went downstairs and wrote this piece in record speed. I literally made money directly tied to napping because this idea jumpstarted the topic for today. That’s the thing with writing. Sometimes you have writer’s block and you are stuck for hours while your fingers are frozen on the keyboard. Other times, words seem to appear on screen like magic while your fingers just keep typing and typing seemingly without much thought.
“Take that, rule of thumb!”
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{ read the comments below or add one }
I think everyone’s rule of thumb is different. When you’re ready to retire from whatever it is you do, you’re going to know if you have enough money to go forward. So the rule of thumb goes out the window.
I sincerely hope that I’ll know with certainty that I’ll have enough to retire when I retire! Who knows what the safe withdrawal rate consensus is by then!
If you keep getting your naps David I’m sure you’re going to have plenty! ?
Hahaha you are right. Balance is key!
I agree rules of thumb are superficial and can be contradictory. It did remind me of the fact they can have some use. In my career I dealt with a lot of lethal and explosive chemicals. We could not afford a design mistake, ever. My boss drilled it into me to always have three ways to come up with an answer, three unrelated ways. One was a detailed calculation or computer model, the second was a chart or comparison to a previous design and the third was a rule of thumb like installed cost should be 1.4 times the purchase price of a piece of equipment. The rule of thumb wasn’t particularly accurate but if your detailed calculation was way different it was likely you made a math error. So I do think rules of thumb are a big help in catching big mistakes sometimes. But not what you want to plan your future on. Great post!
Some rules of thumb are definitely useful. In the personal finance world, I particularly like the rule of 72 where you can roughly calculate how many years it takes to double your money. It’s simple and handy.
I enjoyed the comment from “Ricky Retirement Now” particularly the “Don’t get me started”! I, like Ricky, wouldn’t want to get started on commenting on how many people take comments or suggestions from others as the ultimate answer. Have we gotten to be a society that is unable to think for themselves? I guess that if we receive and act on advice that does not meet our expectations, we feel we have someone other than ourselves to blame. I like to consider advice from others and if it makes some sense to me, stew over it, run several scenarios around it and then make up my own mind how I might be able to intelligently implement it. I do try to run scenarios that are more conservative or “worst case” scenarios so I have some leeway if I do miss the mark.
And to top it off, some people who follow other people’s advice then blame them if the “rule of thumb” doesn’t work in their favor.
As you said, everyone needs to think for themselves!
Don’t get me started on the 4% rule. I think some of those experts started claiming 2.5% or even 2% a decade ago. People who got spooked by those predictions had to sacrifice real spending for 10 years and none of those predictions came true. In fact, with the way the stock market has gone the past 10 years, retirees probably could’ve spent a lot more than 4% and still be okay.
The 4% rule is a contentious topic for sure. In fact, it’s been that way since its inception 30 years ago. Since no one really knows who’ll turn out to be right decades down the road, I don’t see these predictions ever going away. The good news is that the 4% rule is based on surviving the worst case scenarios in market history so far. This means that it’ll take quite a bit of a shock for it to fail in the future.