I thought today, I would discuss some financial rules of thumb. All these rules should be taken with a large grain of salt, but they can sometimes provide an initial starting point from which to work. Please do not consider any of these rules as gospel.
The “Rule of 72” is an actual rule you can use with confidence, as it is mathematical. The rule simply tells you how long it will take for your money to double, at a fixed rate of return.
The formula is 72/interest rate (or annual rate of return) = number of years it will take for your money to double.
For example, if your interest rate is 10%, that means your money will double every 7 years or so (divide 72 by 10 = 7.2 years to double).
A return of 5% will take 14.4 years to double and a return of 7% will take 10.3 years to double.
Retirement Withdrawal Rate
The 4% Rule
Financial planner William Bengen advocated the 4% rule almost 30 years ago to address his clients’ questions about what is a safe yearly withdrawal rate from their retirement portfolio. Mr. Bengen looked to data from as far back as 1926. He determined that given a portfolio split evenly between stocks and bonds, a 4% withdrawal rate (adjusted for inflation each subsequent year) should provide adequate cash flow for a retirement spanning at least 30 years.
The 4% rule has been one of the most debated rules in finance for several years and I have written numerous articles on this topic over the years. Mr. Bengen has suggested in recent years, that an even higher withdrawal rate would be safe, while others suggest a more conservative rate such 3%.
The 4% rule works as follows: say you need $100,000 a year to fund your retirement expenses; you would dividend $100,000/4% and the calculation would suggest you need a nest-egg of $2,500,000. The $2,500,000 nest-egg would allow you take draw $100,000 a year for 30 years without running out of money.
The Rule of 20
For example, if you want to live off $100,000 a year, you will need either $2,000,000 ($100,00 x 20) or $2,500,000 ($100,000 x 25).
You will note the 25 times number brings you to the same retirement nest-egg as the 4% rule; that is because the rule is a derivative of the 4% rule.
The 50/30/20 Rule
This rule was created by Senator Elizabeth Warren (a Harvard law professor when she coined the term) and her daughter, Amelia Warren Tyagi, in the book All Your Worth: The Ultimate Lifetime Money Plan.
This rule of thumb suggests you allocate 50% of your after-tax income to your needs (rent, groceries, utilities etc.), 30% to your wants (hobbies, restaurants, streaming services etc.) and 20% for retirement and savings goals.
A small variation on this rule is the 80-20 plan. Under this method you first set-aside 20% of your after-tax earning into a savings account and the remaining 80% is then spent as needed.
A common rule of thumb is to set
aside three to six months of expenses in an emergency fund. It is suggested the
number of months increase to 8 or more months where you have a job in a
volatile field of work.
Unfortunately, the reality and shortcomings of this rule were reflected when COVID-19 shut down the economy and job market for many people.
How much life insurance you need is really dependent upon your personal situation. A general rule of thumb is you require 6-10 times your gross annual salary in life insurance (in almost all cases this type of insurance should be term insurance, with possibly a conversion option at a future date in the policy). However, the 6-10 multiplier can be higher if you have young children, a mortgage, stay at home spouse etc. You really need to review your specific situation and what you think your family would need if you passed away. I discussed some of these considerations in this 2016 blog.
I have no idea of the origin of this rule, but this rule of thumb states that when an appliance breaks, buy a new one if the appliance is 8+ years old or the repair would cost more than half the replacement cost.
Big Ticket Purchases
The Rule of 10
I like this rule. The rule of 10 is like the twenty-four-hour rule in hockey before a parent can talk to the coach. It provides for a cooling period. The rule of 10 is for large discretionary purchases. The rule says to reflect on how the purchase will make you feel in 10 days, 10 weeks and 10 years.
The cooling period should be equal to one day for every $500-$1,000 of purchase costs, which seems a little long to me. I would suggest a 7-10 day cooling period should be sufficient for most people.