Do you have any favorite financial rules of thumb? I recently ran across an interesting study in which the researchers looked at the impact of formal financial training vs. simplified, rule-of-thumb training on financial decision making.
While the focus of the study was rather narrow (micro-entrepreneurs in the Dominican Republic), the results were quite interesting. In short, they found that “standard” financial training had no impact on business practices and outcomes, but that simplified, rule-of-thumb based training produced “significant and economically meaningful improvements.”
While it’s probably a stretch to take lessons from micro-entrepreneurs in the Dominican Republic and apply them to your family’s budget, I’d be willing to be that there’s some truth to the idea that it pays to keep things simple.
For example, instead of teaching people how to calculate their needs income needs in retirement and how to project their exactly what it will take to get there, simply telling them to save and invest 10% (or 15% or 20%, whatever) for the future.
Likewise, instead of teaching people about modern portfolio theory and the importance of asset allocation, maybe we should just tell them that their percentage stock allocation should be 100 minus their age.
Of course, rules such as these aren’t failsafe, nor should we expect them to be. After all, a rule of thumb is defined as:
…a principle with broad application that is not intended to be strictly accurate or reliable for every situation. It is an easily learned and easily applied procedure for approximately calculating or recalling some value, or for making some determination.Source: Wikipedia
Beyond the inherent limitations of a one-size-fits-all rule, it’s also important to recognize that these rules can change over time. While sometimes these changes are warranted, other times they may not be. For example…
The old “100 minus your age” advice, mentioned above, eventually morphed into “120 minus your age” when modern pundits got their hands on it during the high-flying markets of a decade ago. To be fair, this change was also likely influenced by longer life expectancies, but still… How does that change look in the context of the past three years?
Similarly, the age old advice of spending no more than 28% of your monthly income on your mortgage payment gradually swelled to 30%, then 33%, and finally 36% as housing prices spiraled out of control. Once again, how does that change look in the context of the recent history of the housing market?
But in the end… If preaching rules of thumb spurs people to action – as opposed to overwhelming them into inaction – then maybe that’s where our focus should be.
What are your favorite financial rules?