What is a Rule Of Thumb?
A rule of thumb is a heuristic guideline that provides simplified advice or some basic rule-set regarding a particular subject or course of action. It is a general principle that gives practical instructions for accomplishing or approaching a certain task. Typically, rules of thumb develop as a result of practice and experience rather than through scientific research or a theoretical foundation.
- A rule of thumb is an informal piece of practical advice providing simplified rules what apply in most situations.
- There are many rules of thumb in finance that give guidance on how much to save, how much to pay for a house, where to invest, and so on.
- Rules of thumb are not scientific and do not take into account the individual circumstances and needs of a person, so they may not be applicable to your particular situation.
Understanding Rules Of Thumb
Investors may be familiar with a variety of "financial rules of thumb" that are intended to help individuals learn, remember and apply financial guidelines. These rules of thumb address methods and procedures for saving, investing, purchasing a home and planning for retirement. Although a rule of thumb may be appropriate for a wide audience, it may not apply universally to every individual and unique set of circumstances.
The Rule of 72 is such a quick, useful formula that is popularly used to estimate the number of years required to double the invested money at a given annual rate of return. While calculators and spreadsheets have inbuilt functions to accurately calculate the precise time required to double the invested money, the Rule of 72 comes in handy for mental calculations to quickly gauge an approximate value.
Examples of Financial Rules of Thumb
There are several well-known financial rules of thumb that provide guidance for investors, including the following guidelines:
- A home purchase should cost less than an amount equal to two and a half years of your annual income.
- Save at least 10-15% of your take-home income for retirement.
- 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%.
- You should have an emergency fund equal to six months' worth of household expenses.
- Your age represents the percentage of bonds you should have in your portfolio.
- Your age subtracted from 100 represents the percentage of stocks you should have in your portfolio.
- A balanced portfolio is 60% stocks, 40% bonds.
There are also rules of thumb for determining how much net worth you will need to retire comfortably at a normal retirement age. Here is the calculation that Investopedia uses to determine your net worth:
- If you are employed and earning income: ((your age) x (annual household income)) / 10.
- If you are not earning income or you are a student: ((your age – 27) x (annual household income)) / 10.
Take Rules of Thumb With a Grain of Salt
While rules of thumbs are useful to people as general guidelines, they may be too oversimplified in many situations, leading to underestimating or overestimating an individual’s needs. Rules of thumb do not account for specific circumstances or factors occurring at a particular time, or that could change over time, which should be considered for making sound financial decisions.
For example, in a tight job market, an emergency fund amounting to six months of household expenses does not consider the possibility of extended unemployment. As another example, buying life insurance based on a multiple of income does not account for the specific needs of the surviving family, which include a mortgage, the need for college funding and an extended survivor income for a non-working spouse.