A lot is said nowadays about ‘financial rules of thumb’. In essence, these are ‘shortcuts’ designed to tell you in an instant how to answer some of the biggest financial questions, for example:
How much should I be saving for retirement?
Should I pay off my mortgage or invest with excess income?
How much of my total income should I spend on housing?
Financial rules of thumb will try to give a simple-to-understand solution to these biggest of questions.
One popular example is the 50-30-20 rule which says that you should spend 50% of your income on essentials like housing and food, 30% on ‘wants’ such as holidays and eating out and the remaining 20% should go towards paying down debt or paying off a mortgage.
Another which gets a lot of air-time is the 10% rule which says you should save 10% of your income for retirement.
Before I get on my soap-box and explain why, let me get a few things out of the way.
First of all, if following some financial rule of thumb is the only way in which you are going to engage in your future financial planning and put something towards savings or debt repayment then go right ahead.
I will encourage you in just a moment to do a little more work than that, but if following the rule of thumb is really all you can muster, then something is always better than nothing.
Second, there are people who are far more intelligent and successful than me who advocate financial rules of thumb. They work for some people, I don’t think they are bad, but I also don’t think they are good. I think you can do better!
With that said, let me tell you some of the reasons why I don’t think following a rule of thumb is a great idea.
In my career, I must have advised well over 1000 people on how they can get what they want in their financial life. The only thing that they have in common is that no one of them was the same as another.
We all have very different current circumstances and objectives. Rules of thumb take no account of any of this.
For example, lets say we have 3 people as follows:
Person 1 – Earns $12,000 a year, is $20,000 in debt on high-interest credit cards and is struggling to make ends meet.
Person 2 – Earns $50,000 a year, has a mortgage on their home at 2% interest and has around $300 a month of excess income.
Person 3 – Earns $250,000 a year, has no debt and over $5,000 a month of spare income.
Clearly each of these 3 people have very different circumstances. Following the 50-30-20 principle for person 1 would clearly be ridiculous. I suspect if you analysed their budget, you would find that at least 90% of their income was spent on needs and the remaining 10% was being used to service (not repay) that debt. 50-30-20 is so out of reach for them it is barely worth mentioning.
Person 2 might be the one for whom the 50-30-20 rule would work best. They might have the capacity to reduce their expenditure on ‘wants’ and increase the amount they put towards debt repayment.
However, you have to beg the question – should they repay the debt at all? At an interest rate of 2%, they could very well earn more if they invested that money and inflation will eat away at the value to be re-paid in future years.
For person 3, the 50-30-20 rule is probably a bad idea as well. With an income of $250,000 and no debt, I would argue that they could afford to save and invest way more than 20% of their income (perhaps up to 70 % or 80% at the extreme end).
Bear in mind that we haven’t even spoken about their objectives yet. Person 2 might love their job and have no plans to ‘retire’, ever!
Person 3 on the other hand hates what they do and wants to get out as soon as possible, despite their amazing income.
In this situation, person 3 probably needs to have a much greater savings rate than the 20% recommended by the rule of thumb, while person 2 might be able to get away with a bit less on account of the fact that they will always have an income so long as they keep working.
But, person 2 might want a lifestyle filled with flying first class and staying 5* where as person 3 might be happy flying coach and staying 3*.
All of these different factors will play into the right financial plan for an individual, making rules of thumb seem a bit silly.
Another problem with financial rules of thumb is that they offer a bit of an ‘all or nothing’ solution to a financial question or problem.
Take person 1 from the example above, clearly saving anything like 20% of their income is totally out of reach, but saving 1% would be a start.
The rule of thumb has the potential to make people in this situation feel bad and give up because they can’t achieve the 20% recommended savings rate. But, surely something is better than nothing. Aim for 1% to start with then build on it from there.
What all of the above things have in common is different circumstances. When trying to answer some of the big financial questions such as ‘how much should I save for retirement?’ clearly the answer will depend on a whole host of different factors.
When do you want to retire?
What sort of lifestyle do you want when you get there?
Is retiring quickly more important than the lifestyle you will have when you do retire or are you absolutely focused on having the best lifestyle possible and willing to work a few more years to get it?
In my work with clients, I have met people who don’t need to save anything more to achieve their retirement goals (they already have too much money – nice problem to have!) but I have also met people who would need to save more than 100% of their income to achieve their objectives (they better think of some compromises and quickly).
Although financial rules of thumb provide a good starting point, I believe that they are too simplistic to really give you the answers you desire.
The only way to get the right answer for you is to do some work. You have to do a budget that is personal to you, work out what you want in your future and then figure out ‘your number’ – how much money you need to get there.
If you want to work through this process, I recommend you sign up for my 7 Day Fast Track Financial Freedom E-mail course, which will walk you through all the steps to create an individual, personalised financial plan. Just fill in your details in the box below.