Tuesday, February 16, 2016

Rules of Thumb...


Rules of Thumb are used to express complex concepts in simple terms.  While on occasion they can be somewhat limited in value, for the most part they have great value in everyday life.


In reviewing the wisdom of the 4% rule the other day, I ran a lot of different scenarios regarding retirement money and came to the conclusion that the "rule of thumb" was actually a pretty good representation of what was a very complex mathematical formula that could have thousands of scenarios.

And it struck me that these "rules of thumb" are not necessarily all that bad, for the most part.  They allow us to take very complex mathematical problems and reduce them to the simplest terms, which in turn helps us better manage our finances - or whatever.

And there are rules of thumb for a lot of whatever - everything from calculating the amount of board feet of lumber for a building project to how long to bake a cake.  They represent a collective wisdom, sort of a Wiki if you will, on how to best get things done.

From a financial standpoint, there are a number of "rules of thumb"out there which make a lot of sense.  And what we've seen in the past, is that when people discard these "rules of thumb" as being "outdated", well, bad things pile up in a hurry.

But note, don't confuse a "rule of thumb" with a mantra (my next posting).   Rules of thumb are based on calculations and math.  Matras are based on wishful thinking.

Here is a short list of some Rules of Thumb that I think make sense, in terms of personal finance.

1.  Don't buy a home unless you plan on keeping it at least five years:  In a normal Real Estate Market, the transaction costs of buying and selling a home can easily be 10% or more.  At 2% annual appreciation, which is the norm, it can take 5 years or more to recoup those transaction costs - and break even.  If you sell before the 5-year mark, chances are, you will lose money, as simple as that.

2.  The 4% Rule:  In retirement, if you spend no more than 4% of your savings in any given year (adjusted for inflation after the first year) you should have enough money to last you 25 years or more.  You can go through the complex calculations and scenarios, but for most people, this represents the safety net level of spending, where the odds of outliving your money are very, very slim.

3.  The Best Automotive Value is a Late-Model Used Car:  If you buy a brand-new car, the minute you get it home, it is a late-model used car.  But it is one you paid 20% too much for.  If you can find a used car, 1-3 years old, with 30,000 miles or less on the clock, in good shape, it represents the best value for the dollar, as it hits the "sweet spot" on the depreciation curve, in that a huge chunk of initial depreciation has come off, and it will depreciate fairly slowly for the next 3-5 years.  Such a vehicle can last as long as any new car, if properly cared for.  And most are still under warranty.

4.  Save 10% of your income:  It may seem hard to do, at any time in life, but for our generation, who is not assured a defined benefit pension, saving is not merely desirable, but essential.  How much to save is a hard number to crunch, but 10% seems like a reasonable goal, particularly considering that it is tax deductible in a 401(k) or IRA.   And no, please don't tell me you can't afford to save because you are living "paycheck to paycheck" while texting me on your new smart phone.  There's your 10% right there.

5.  A year's salary saved by age 30:  Again, this seems like a hard thing to do, and I certainly failed at this goal (although by age 35 I was far over it).  Others have different numbers or targets for age 40, 50, and so on.  The idea here is to have some goal, and this rule of thumb insures you will have enough saved to retire by age 65.

6.  The percentage of your savings in "safe harbors" should equal your age:  Again, this is a flat rule, but one that makes sense.  By age 70, you are not going to make a lot of money off of investments, but you want to preserve savings.  So 70% should be in safe and boring things, not stocks and corporate bonds.

And so forth....

There are of course, a lot more.  For example, see these sites:

http://www.bankrate.com/finance/retirement/8-rules-of-thumb-on-saving-and-retirement-1.aspx

http://twocents.lifehacker.com/10-good-financial-rules-of-thumb-1668183707

http://www.getrichslowly.org/blog/2009/03/09/25-favorite-financial-rules-of-thumb/

http://business.time.com/2012/12/28/9-handy-financial-rules-of-thumb/

http://realdealretirement.com/3-retirement-rules-of-thumb-that-actually-work/

The point of a "rule of thumb" is to take complex economic equations and reduce them to simple terms than you and I can use on a daily basis without resorting to calculus.   And people use these in all walks of life.    A contractor can look at a set of blueprints and using a "rule of thumb" based on square footage tell you the cost of construction in a matter of minutes - and how many board-feet of lumber are needed.

Your doctor can measure your height and weight and have a good guesstimate of your body mass index, without you having to strip down to your skivvies and sit in a tank of water.   Rules of thumb help us by taking complex data and reducing it to a simple equation.

They are, of course, no substitute for "doing the math" on any topic.  If the "rule of thumb" shows that something is promising, then you can get out your pencil and see if it really will work out.  For example, in renting out a condo or house, I could guess pretty accurately whether I would make money on the deal by using "rules of thumb" to guess at mortgage, tax, and insurance costs.  But of course, later on, I would get out my calculator or spreadsheet and go to town on the numbers to see exactly what I could budget for the project.

 Some of these "rules of thumb" are numerically based such as the 50/30/20 rule, others are basic good advice (e.g., "Never co-sign a loan!").   The point is, there is some logic behind these "rules" that you can analyze and see if it fits your situation.

In most cases it does.  Rarely does it not.   There are few, if any circumstances where saving money is a bad idea and spending it is a good one.

But that doesn't stop the marketers from coming up with their own "rules of thumb" - or mantras as I call them, which is the subject for the next posting.

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