What is... | August 4, 2014

What is a rule of thumb in personal finance?

You may have heard people talk of their aim to save 10% of pre-tax income each pay day, or to spend less than 30% of after-tax pay on rent. These are known as “rules of thumb” in personal finance.

There is debate about whether rules of thumb make financial choices easier and help overcome the problems of procrastination and low levels of financial competence – or whether they are too simplistic, are financially dangerous and fail to take individual circumstances into account.
It seems likely that rules of thumb are a quick and memorable way to help guide simple money choices but might not be suitable for more complex financial decisions.

Some “smart shortcuts”
In addition to the savings goals and rent costs above, rules of thumb exist for investing and other money choices.
Chicago professor Harold Pollack’s index card, reproduced on the Washington Post, lists some of his rules of thumb including saving 20% of income, paying off credit cards in full and choosing funds based on criteria such as being passively managed, diversified and with low fees.
Undercover Economist author Tim Harford mentions on his blog a rule of thumb that debt payments should be no more than 36% of pre-tax income.
Another widely known rule of thumb is to have “100 minus your age in shares" (so at age 30, 70% of long term investments would be in shares, compared with a 50-year-old’s 50% exposure to shares). This has similarities to life cycle investing.

Coaching small business owners
Ideas42 recounts a trial in the Dominican Republic that tested whether basic rules of thumb (such as keeping business and the household finances separate by putting them in two separate drawers) were a better fit for “less financially sophisticated” small business owners than a standard accounting programme. It found microentrepreneurs given rules of thumb training were more likely to use what they learned than those undergoing the traditional training.
Rules of thumb are shortcuts used to simplify decision making and are a type of heuristic, discussed widely by Nobel Prize recipient Daniel Kahneman, his late research partner Amos Tversky and other leading thinkers. But sometimes we take a shortcut to the wrong conclusion.

Are they smart enough?
In a 2011 study, Williams College’s David Love writes that the unacknowledged source of many of the rules of thumb seems to be Burton Malkiel's influential book A Random Walk Down Wall Street but that the book “provides considerably more subtle advice than the abridged versions offered on many personal finance websites and news articles”.
Love tells how Malkiel recommends life cycle allocation of shares, for example, that approximates a “linear age” rule, but that emphasises the need to take into account individual’s housing costs, health, risk tolerance and income uncertainty.
Love goes on to develop a framework to select optimal rules of thumb.
Similarly, economist and writer Chris Dillow picked a study by Javier Estrada at IESE Business School in Barcelona among his top five lessons for 2013. Estrada calculates that, for most countries, advice to own fewer shares and more cash or bonds as you get older leads to lower retirement wealth than the opposite strategy, of investing more in equities as you age.
“Some rules – popular as they are – are wrong,” wrote Dillow.


eZonomics team
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