“Heuristics are simplified rules of thumb that make things simple and easy to implement. But their main advantage is that the user knows that they are not perfect, just expedient, and is therefore less fooled by their powers. They become dangerous when we forget that.” – Nassim Nicholas Taleb
In the spirit of Taleb’s quote, the following financial rules of thumb are not set in stone. They are simply guidelines to remind us of important principles and keep us from going too far astray. Use them with that in mind and they will be very helpful.
(1) The Credit Card Debt Rule: “If you… have credit card debt, your first step to financial security should be to get rid of that debt as soon as possible.” – Burton Malkiel
In his book The One Page Financial Plan, Carl Richards said, “Imagine if I offered you an investment opportunity that had a guaranteed return rate of 15, 18, or even 22 percent. I suspect that, even if money were a little tight, you’d find a way to get in on the ground floor. And yet, if I told you that you could make the same amount of money by paying down your credit card debt, you’d probably find a number of excuses why that just isn’t possible right now.”
If you have credit card debt make paying it off a priority. No other risk free investment can come even close to offering the same reward.
(2) The Automobile Sanity Rule: “The value of all your automobiles should be less than half your annual income.” – Dave Ramsey
Why is this rule important? Because cars lose value faster than any other major purchase you will make.
The road to financial security is paved with acquiring assets that increase in value over time. The road to financial trouble is paved with purchases that lose value over time, and cars are the chief culprit. If you spend too much of your income on cars you will not have the resources necessary to achieve your financial goals.
Further Reading: Cars are the Great Middle Class Wealth Destroyer
(3) The Mansion Is Not a Great Investment Rule: “If you’re not wealthy, but want to be someday, never purchase a home that requires a mortgage that is more than twice your household’s total annual realized income.” – Thomas J. Stanley and William D. Danko from their landmark book, The Millionaire Next Door
Unlike cars, houses generally don’t destroy wealth. However, they don’t create it nearly as fast as most people believe. Research has shown that over the long term, when real estate taxes and maintenance are taken into consideration, houses return around 3 percent annually.
So why do people think their houses have been such good investments? Carl Richards hit the nail on the head when he said, “Sadly, because it was the only investment they ever owned for that long.” Limiting your housing debt to no more than twice your annual income will allow you to acquire other assets that grow in value much more quickly.
(4) The Intelligent Insurance Rule: Purchase insurance to protect yourself against future events only if they would be both catastrophic and unlikely. – Moshe Milevsky from his book Your Money Milestones: A Guide to Making the most Important Financial Decisions of Your Life
Insurance is a profitable business and most insurance companies make money. Therefore, whenever you purchase insurance the odds are against you. This is why you should only insure against catastrophic events. Protect yourself against life’s smaller disasters by setting up your own “Small Risk Fund”. Self-insuring against life’s smaller disasters will likely pay off handsomely in the long-run.
(5) Grandpa’s Rule: Save 10 percent of everything you make.
This is the oldest and simplest rule of thumb in personal finance. The reason it has been around so long is because it works. In fact, saving some of what you earn is really the only thing that works. Saving 10 percent of your income will result in peace of mind and financial security.
While the rule is simple it is not easy to do. Warren Buffett nailed the key to implementing this rule when he said, “Do not save what is left after spending, spend what is left after saving.”
Craig Matters, former editor of Money Magazine, gave further advice on the easiest way to make this happen when he said, “…you can use technology as a substitute for willpower by having funds automatically deposited into retirement or other savings and investment accounts.”
(6) The Rule of 72: “The Rule of 72 provides a wonderful illustration of the magic of compounding. To quickly approximate how many years are required to double the value of an investment, simply divide the rate of return into 72: a 4 percent return takes about 18 years; 6 percent, 12 years; 10 percent, 7 plus years; and so on.” – John Bogle
Of course, this assumes you are not adding to your initial investment. If you continue to make regular deposits into your account your investment will double much quicker.
Bogle also uses the Rule of 72 to estimate how long it will take to create a future income stream of a given amount. Bogle states, “For any given rate of return, the Rule of 72 shows how many years you must regularly invest a given sum before you can stop investing and then start withdrawing the same amount without depleting your capital. For example, if you invest $500 per month at a 6 percent rate of return, after 12 years (72 divided by 6) you could regularly withdraw $500 per month and still leave your principle untouched… But if your rate of return were 12 percent, your waiting time would be shorter: six years to begin $500 monthly withdrawals.”
The Rule of 72 is a very useful tool to help us understand the power of compounding and to estimate the future growth of our investments.
Further Reading: Don’t Underestimate the Incredible Power of Compound Interest
(7) The Leaky Bucket Rule: “Mutual fund charges look small but the cost of paying an extra 1% a year in fees is that you give up 33% of your potential wealth over the course of 40 years.” – May 2015 Issue of Money Magazine
How is this possible? How can a 1 percent annual fee reduce your wealth by 33 percent? First, the 1 percent fee is 1 percent of your total account value, not 1 percent of your gains in a given year. Second, the effect of these fees compounds over time.
Small things can truly become great things, and the 1 percent fee you are paying can end up costing you several hundred thousand dollars over your investing life. This is why low-cost index funds beat most other mutual funds over time. Patching your leaky investment bucket is possibly one of the best investing moves you can make.
Further Reading: John Bogle and the Cost Matters Hypothesis, What I Wish I Knew About Investment Costs Twenty Years Ago, Looking at Investment Costs from the Proper Perspective Changes Everything, The Parable of the Leaky Bucket
(8) The Young & Bold, Old & Cautious Rule: “My favorite rule of thumb is (roughly) to hold a bond position equal to your age – 20 percent when you are 20, 70 percent when you’re 70, and so on – or maybe even your age minus 10 percent. There are no hard-and-fast rules here. (Most experts think my guidelines are too conservative. But I am conservative.)” – John Bogle
The single biggest factor influencing investment returns is your portfolio’s exposure to stocks. The more exposure you have to stocks the higher your return is likely to be given enough time. However, stocks are volatile making them dangerous for older investors who will need their money sooner rather than later.
The principle at work here was expressed eloquently by John Kay in his book Other People’s Money: “The more extended the time-scale, the greater the likelihood that an investment strategy that on average yields a higher return will actually do so.”
I hesitated using this rule because I believe much more should go into an asset allocation decision than just the investor’s age. However, it does remind us of the important relationship between risk and time horizon and helps investors avoid the possibly devastating consequences of taking too little risk when young and too much risk when close to or in retirement. And by the way, I do think Bogle’s guidelines are too conservative.
Further Reading: How Much Risk Should You Take?, How Much Risk Do You Need to Take?, How Much Risk is Wise for You to Take?, How Much Risk are You Willing to Take?, Asset Allocation: Putting It All Together
(9) The When Can I Retire? Rule: “When will I be able to retire? That is the most common question people ask my colleagues and me. Our answer for most people: You will be able to retire 30 years after you begin saving.” – Ric Edelman in his book The Truth About Retirement Plans and IRAs
Why 30 years? Because it takes that long for compounding to work its magic. Under most circumstances 30 years of living Grandpa’s Rule will allow you to replace most of your pre-retirement income for at least 30 years of retirement.
Further Reading: The Expanding Lily Pad: A Retirement Riddle
(10) The 4 Percent Retirement Withdrawal Rule: “If you want to make inflation-adjusted withdrawals, increasing the amount withdrawn each year in accordance with increases in cost of living, begin by withdrawing no more than 4 percent of the portfolio’s beginning value.” – From the book The Bogleheads Guide to Investing
The 4 percent rule is based on simulations projecting market conditions from the past into the future. It is a conservative rule that would give your portfolio a high probability of surviving for at least 30 years under even the worst conditions experienced in the last 100 years.
Under most scenarios a 4 percent withdrawal rate will leave you with more in your portfolio after 30 years than you started with, often substantially more. Withdraw more than this annually and the chances of running out of money during retirement increase.
The 4 percent rule can also be used to estimate how much you need to save for retirement. This is done by figuring out how much income you will need each year and dividing this amount by 4 percent. For example, if in addition to Social Security you need to generate $40,000 of income per year, you would need a nest egg of $1,000,000. The calculation would look like this: $40,000/.04 = $1,000,000.
Further Reading: How Much Do You Need to Save for Retirement
(11) Bonus – The 48-Hour Rule: Wait 48 hours before making an impulse purchase. If you still want it after 48 hours, and you can afford it, go ahead and buy it. Chances are you will have forgotten all about it by then. This is from The Only Investment Guide You’ll Ever Need, by Andrew Tobias.
Not Perfect, But Pretty Darn Good
Investing legend and founder of The Vanguard Group, John Bogle, once said of the simple investing advice he gives, “There might be advice out there that’s better than this, but the amount of advice that’s worse is infinite.”
That’s the way I feel about these financial rules of thumb. They aren’t perfect for every situation, but they will point you in the right direction and keep you from straying too far off the road that leads to financial security and independence. Use them along with a little common sense and you will be on your way.
What are your favorite financial rules of thumb? I would love to hear everyone’s ideas.