A collection of financial rules of thumb

Decision-making, be it for personal or professional reasons, is an ever-present aspect of our lives.

Personal decision-making can include important financial decisions such as long-term savingsmanaging investmentsbudgetingusing credit, and undertaking large purchases.

Unfortunately, when it comes to making a financial decision, we can experience considerable cognitive pressure—especially when the financial decision is complex and time-sensitive.

Cognitive pressure coupled with our cognitive biases and emotions, can impact our ability to make a financial decision. This can sometimes result in us not making a financial decision and not taking any action at all.

If left unaddressed, this ‘decision/action paralysis’ can be costly for our personal finances, both now and in the future. As such, in certain circumstances, initially utilising a financial rule of thumb can be helpful.

A financial rule of thumb can help reduce cognitive pressure, and the effect of cognitive biases and emotions, by providing a ‘decision shortcut’—a general guideline or approximation to base initial plans and promote initial actions.

It must be noted that utilising a financial rule of thumb can produce a ‘suboptimal positive outcome’. However, this may still be more beneficial, at least initially, than decision/action paralysis.

It’s, therefore, important to understand that an ‘optimal positive outcome’ can be produced where plans and actions are based upon our personal circumstances (financial situation, goals and objectives).

As such, keeping the last point in mind, below is a general overview of a collection of financial rules of thumb. This is assisted by a recent research paper*, which evaluated many of the most well-known ones.

 

Saving, 6-month emergency buffer/fund rule

A simple savings ambition.

This rule of thumb highlights that an emergency buffer, such as 3 to 6 months of your living costs, housed in a high-interest savings account or mortgage offset account, can help you weather a financial emergency, such as:

For more information on emergency buffers, please click here.

 

The 4% withdrawal rule

A simple withdrawal in retirement rule.

This rule of thumb highlights that the transition from employment income to retirement income—and the need to spend accordingly—can assist in mitigating certain retirement-related risks, such as longevity risk.

In most cases, this transition can require a reduction of your lifestyle expenses to accommodate a drop in your total household income. Adjusting to this can be difficult, especially when first commencing retirement.

For example, there can be the temptation to keep your pre-retirement lifestyle afloat with larger than planned drawdowns from your retirement savings (superannuation retirement income stream).

However, it’s important to understand that your retirement savings are a finite resource. The drawdowns you make to fund your retirement lifestyle need to be sustainable for the long-term.

For more information on retirement withdrawal rules, please click here.

 

The ‘Young and Bold, Old and Cautious’ rule

An investment rule of thumb, designed to lessen risk-taking closer to retirement.

This rule of thumb highlights several important things when it comes to investing (both inside and outside of super).

Firstly, an investment risk profile established according to your personal circumstances can ensure you are invested appropriately, now and into the future. An appropriate investment risk profile considers your:

Secondly, when considering time horizons, in general:

  • If you have a long-term time horizon, you do not need immediate or significant income, you are comfortable with volatile investment values, and you want to grow your assets—growth asset classes, such as property and shares, can be a relevant consideration.
  • If you have a short-term time horizon, and preserving your capital is of high importance—defensive asset classes, such as cash and fixed interest, can be a relevant consideration.

This also highlights the fact that your investment risk profile may change in time (as you approach retirement).

For more information on investing, investment risk profiles and time horizons, please click here.

 

Windfalls should be held for a period of time before spending them

The initial excitement of a windfall will diminish, allowing you to make better financial decisions.

This rule of thumb highlights that the receipt of a windfall can bring about temporary states of emotion, and if acted on, can lead to overspending on short-term want items—often the seed for guilt and disappointment later on.

There are many sobering statistics regarding the financial loss following the receipt of a windfall (or inheritance). Often money received by luck or circumstance can be easier to spend than money earnt through hard work.

By waiting for these temporary states of emotion to subside, and then proactively putting a plan in place, you can ensure the windfall is used appropriately—in accordance with your financial situation, goals and objectives.

For more information on windfalls, please click here.

 

Budgeting 50/30/20

A budgeting rule comprising of needs (50% of income), wants (30% of income) and savings (20% of income).

This rule of thumb highlights budgeting as a foundational block when it comes to building and maintaining wealth. However, making informed decisions on how to manage your money can be difficult.

The 50/30/20 budgeting rule can be a useful starting point as it can provide a general guideline as to how much money you should potentially be allocating towards your needs, wants and savings.

Furthermore, by breaking up your money into the above categories and percentages, you can create a balance between your obligatory and discretionary costs, and the funds required to achieve your goals.

For more information on the 50/30/20 budgeting rule, please click here.

 

Pay off your smallest debt first

Paying off the first debt should motivate further debt repayment.

This rule of thumb highlights that focusing your efforts on paying off your smallest debt first—while maintaining minimum repayments on all other debts—can be a beneficial debt management strategy.

Commonly dubbed the ‘debt snowball method’, you can gain the momentum (and the motivation) to continue the same process with all other debts.

Another strategy, commonly dubbed the ‘debt avalanche method’, can be to focus your efforts on paying off your debt with the highest interest rate first—while maintaining minimum repayments on all other debts.

For more information on debt management strategies, please click here.

 

If you’re not willing to pay cash for it, don’t buy it on credit (& credit cards can lead to overspending)

Prevents unwise and/or unaffordable purchases (& avoid credit card debt).

This rule of thumb highlights that the management of your money can include taking a mindful approach to your use of credit. A research study^ found that people spent more when using credit cards as opposed to cash.

The reason? Their perception of the money changing hands. Cash is tangible—the paper they hold in their hand has a perceived value. When they spend that paper money, they are aware of it leaving their possession.

Importantly, this financial rule of thumb can also extend to consumer purchases made via ‘buy now, receive now, pay later’ services offered by providers, such as Afterpay, Zip and Humm.

For more information on consumer purchases, please click here.

 

Homeownership 20% rule

20% deposit on a home to ensure you can afford the property and ensure manageable mortgage costs.

This rule of thumb highlights that when saving (and purchasing a home) an appropriate home deposit can typically represent a loan to value ratio (LVR) of ≤80%. So what’s the rationale behind this rule of thumb?

A ≥20% deposit can give you greater equity in your home and a reduction in your mortgage commitments, it also helps you avoid Lenders Mortgage Insurance or a loan guarantor arrangement.

However, it’s important to understand that while a ≥20% deposit will help with the purchase of your home, you also need to cover the acquisition costs, such as the conveyancing fees and any applicable stamp duty.

For more information on homeownership and the initial and ongoing costs involved, please click here.

 

Other notable rules of thumb

If you have any questions regarding this article, please contact us.