How to Use Financial Rules of Thumb
Updated: Jun 13, 2020
If used properly, financial rules of thumb are a great resource to understand complex financial topics. This post is a guide on how to use financial rules of thumb.
The intended use of a financial rule of thumb is not to give you the exact instructions on managing your finances, but to get you “in the ballpark.” The proper way to use a financial rule of thumb is to use it as your starting point, not your ending point when researching financial topics.
Let’s examine the most commonly used financial rules of thumb and how you can use them to make better financial decisions.
7 Popular financial rules of thumb
To better understand how to use financial rules of thumb, let’s review seven of the most commonly used rules of thumb in personal finance.
The 4% rule.
The 25 Times rule.
The rule of 110.
The 1% rule.
The 50/30/20 rule.
The 5% rule.
The wealth equation.
I’ll discuss how to use each of these rules of thumb and highlight each of their assumptions and limitations. As we highlight the flaws, I’ll discuss whether each rule of thumb can be modified to be more useful or whether it should be discarded entirely.
The one thing all of these rules of thumb have in common is that they force you to think about an important financial topic. Even if a rule of thumb does not give you the answer, it can act as a crucial first step in obtaining the answer.
The 25 times rule and the 4% rules
While these are technically two different rules of thumb, they are often used together to help answer the same question; “how much money do I need to retire?”
The 25 times rule states that once you have saved up 25 times your annual living expenses, you have enough money to retire.
The 4% rule states that you can withdraw 4% of your retirement nest egg to fund your first year of retirement. In the following years, you increase how much you withdraw by the rate of inflation.
You might notice the mathematical similarities between the 25 times rule and the 4% rule, 4%=1÷25.
The 25 times rule and the 4% rule are two sides of the same coin. The 25 times rule tells you how much money you need to have saved to retire. While the 4% rule tells you how to ensure you don’t run out of money in retirement.
An example of the 25 times and 4% rules
Let’s say your projected annual living expenses in retirement were $40,000.
Using the 25 times rule, you estimate you would need $1 million ($40,000 times 25) to retire.
Using the 4% rule, you estimate you could withdraw $40,000 (4% of $1 million) in your first year of retirement.
For the rest of your retirement, you increase your withdrawals by the rate of inflation. If inflation was 2%, then in year two of retirement, you would withdraw $40,800 from your retirement nest egg.
Assumptions & limitations of the 25 times and 4% rules
There are two research papers that the 25 times and 4% rules are based on.
In 1994, William Bengen published a paper in the Journal of Financial Planning, Where he used historical U.S data to build a 50–50, stock-bond portfolio to find the highest sustainable withdrawal rate for a 30-year retirement. The study concluded that the maximum “safe” withdrawal rate was 4%.
A second study that has become known as “the trinity study was completed in 1998. The trinity study has a similar conclusion that a 4% withdrawal rate would prevent 95% of retirees from outliving their money.
The 25 times rule and the 4% rule rely on two key assumptions.
They were modeled using U.S data, and a 50% stock, 50% bond portfolio.
The maximum length of the retirement was 30 years.
Given where bond yields are at the time I write this, it would be difficult to expect the same returns going forward from a 50–50 portfolio.
Life expectancy, and retirements, were much shorter when these studies were completed in the 90s. If you retire at 55 and expect to live to be 100, that is a 45-year retirement, which is 50% longer than the assumption baked into the 4% rule.
Modifying the 25 times and 4% rules
While these rules of thumb are a great way to quickly give you a rough estimate of how much you might need to save for retirement, it’s important to take all of your circumstances into account when creating a DIY retirement plan.
For example, if you expect to receive income in retirement through workplace pensions, government pensions/benefits, or rental income, you may not need to save 25 times your expenses.
If you expect to retire longer than 30-years or simply want to give yourself a higher margin for error, you may want to choose a withdrawal rate that is lower than 4%.
Here is a quick tip to modify the 25 times rule if you choose a withdrawal rate lower than 4%. The amount you need to retire is equal to your desired income from savings divided by your withdrawal rate.
To generate $40,000 in retirement income using a 3.5% withdrawal rate would require you to save $1,142,857 ($40,000 ÷ 3.5%).
The rule of 110
The rule of 110 is a rule of thumb that states that the amount of your portfolio you allocate to risky investments like stocks, should be equal to 110 minus your current age.
A 20-year old using the rule of 110 would have a portfolio of 90% stocks and 10% bonds.
A 60-year old using the rule of 100 would have a portfolio of 50% stocks and 50% bonds.
The basic premise behind the rule of 110 is that younger investors can more easily take risks compared to older investors.
If you are decades away from retirement, you have a long time to recover if the stock market goes in the tank.
On the other hand, if you are in retirement and too much of your portfolio is in stocks, a market crash could be devastating to your retirement plans.
Why I don’t like the rule of 110
With any rule of thumb, you are making a trade-off between simplicity and accuracy.
Sometimes, that trade-off is tolerable, especially if there are simple modifications that can be made to the rule of thumb.
The rule of 110, is too simplistic and only considers one factor, the investor’s age. While the investor’s age is an essential factor to consider when choosing an asset allocation, other important factors must also be considered.
Other assets and streams of income.
Determining your asset allocation is too important of a decision to be determined simply by your age.
A simple alternative to the rule of 110
Rather than use the rule of 110, why not take all relevant factors into account when deciding on your asset allocation. Vanguard has created a simple questionnaire to help you determine how much of your portfolio should be allocated to risky assets like stocks and lower risk assets like bonds.
The 1% rule
If you are going to invest in real estate, you will need to know ahead of time if the property you are considering buying is likely to be cashflow positive. Meaning, you want to know if the income the property generates through rent will be more than all of the operational costs associated with the property.
One rule of thumb that many real estate investors use to determine if a property is likely to be cashflow positive is the 1% rule. According to the 1% rule, the rent generated from the property should be at least 1% of the purchase price.
If you were buying a $300,000 property, the monthly rent would need to be $3,000 to meet the 1% rule.
I like the 1% rule because it is a handy, straightforward calculation that anyone can quickly perform. However, let me be absolutely clear, you should not make a real estate investment based on a rule of thumb like the 1% rule.
There are many other important factors to consider when buying real estate. There are plenty of properties that clear the 1% rule that I would never invest my money in.
If you are thinking about investing in real estate, go find some trustworthy real estate specific resources. One of the most popular online real estate resources is BiggerPockets which I would describe as a platform for real estate investors, by real estate investors.
The 5% rule
Let’s stay with the theme of real estate. Without a doubt, the most frequently asked real estate question is, “does it make better financial sense to rent or buy a house?” The 5% rule aims to help you answer that question with an ultra rational approach.
The 5% rule was created by Ben Felix, a portfolio manager based in Ottawa, Canada, and the host of the Common Sense Investing YouTube Channel. The 5% rule is a calculation of the “break-even point” on the buy vs. rent decision. Here’s how the 5% rule works.
Multiply the value of a house by 5%
Divide by 12.
This is your break-even point. If you can rent a comparable home for a lower monthly rent, it makes sense to rent.
If the monthly rent for a comfortable home is higher, it makes sense to buy.
An example of the 5% rule
Let’s say you are considering whether to buy a $500,000 house.
5% Of $500,000 is $25,000.
$25,000 ÷ 12= $2,083.
If you can rent a comparable home for less than $2,083, then renting makes good financial sense.
If the rent for a comparable home is more than $2,083, then buying makes more sense.
The math and assumptions behind the 5% rule
This get’s a bit complicated, but here is how Ben Felix comes up with the math for the 5% rule. As I said before, it is all about comparing the cost of renting vs. the cost of owning.
The cost of renting is simple; it’s the rent and renters insurance you must pay.
The cost of homeownership is a bit more complicated because there are a lot of invisible costs associated with homeownership.
Ben breaks down the annual cost of homeownership into three categories, which total 5%.
Property tax: 1%
Home maintenance 1%
The cost of debt /cost of equity: 3%.
The 3% to the cost of debt and equity is where things get a bit more complicated.
The cost of debt is assumed to be around 3%, which is what Ben assumed would be the average interest on a mortgage at the time he made the video.
The 3% cost of equity is the difference between the expected return on your home vs. the expected return of investing in the stock market. It is the opportunity cost of owning a home rather than investing in the market.
Rather than me explain it, why don’t I let Ben Felix explain it in his own words in this video.
Limitations of the 5% rule
I’m a fan of Ben’s YouTube channel and Podcast. He approaches all financial decisions from a hyper-rational point of view. The 5% rule makes sense to me, but I was trained to think like an economist.
The 5% rule is based on the assumption that you would invest every penny that you were not putting into your house. Which, on paper, sounds great. But, in reality, we know that most people do not have the level of discipline required to invest the total amount of money they should be to make the 5% rule work.
The main reason I think owning a home is an excellent idea for most people is that while people are bad at saving, they are generally very good at making their mortgage payments. In that way, homeownership provides forced savings.
For that reason, I don’t think the 5% rule would work for most people.
The 50/20/30 rule
The 50/20/30 rule is a rule of thumb to help you create a simple budget.
Here’s how a 50/20/30 budget is broken down.
50% of your money should be spent on “needs.”
30% of your money should be spent on “wants.”
20% of your money should go to saving and investing.
If you are serious about getting your finances together and you want a quick and easy way to create your first budget, the 50/20/30 rule will do just fine.
Personally, I am not a fan of arbitrary spending and saving rules. It’s one of the reasons most people simply don’t use a budget.
A budget is nothing more than a “plan” for how you will spend your money. To quote Mike Tyson, “Everyone has a plan until you get punched in the mouth.” It’s easy to say that you won’t spend more than 30% of your income on “wants,” but once you leave your house, everyone you meet is trying to get you to part with your money. Sooner or later, your budget goes out the window.
Here’s a more straightforward, more effective way to manage your finances. Figure out how much money you need to contribute towards your financial goals each month, automate the savings, investing, and debt repayment process and spend whatever is leftover.
The wealth equation
The wealth equation was created by Dr. Thomas J. Stanley, author of “The Millionaire Next Door.” It is intended as a rule of thumb to help you determine if you are as “wealthy as you should be,” given your current age.
The Wealth Equation= (10% X Age of breadwinner) X Household income. If you are age 40 and make $60,000 per year and your spouse is 44 and makes $89,000 per year, then according to the wealth equation, you should have a net worth of $655,600 (4.4 X $149,000).
While it is not an exact science, it is a useful gauge to determine if you are on track to hit your financial goals. If the wealth equation tells you should have an $800,000 net worth, and your net worth is only $75,000, you know you have some work to do.
The wealth equation does not make sense for young people
Given the reliance on age as a variable, the wealth equation does not work for younger people.
If you are 28 and just got promoted to making $125,000 per year, it’s not reasonable to expect that you would have a $350,000 net worth.
However, as you get older, the expectation is that you will be saving and investing more of your money. As time goes by, those savings begin to compound, and the wealth equation becomes a more useful tool to see if you are on track.
While I don’t put too much stock into the wealth equation, if it gets you focused on tracking your net worth and creating financial goals, that is, without a doubt, a good thing.
Financial rules of thumb are a great starting point
Financial rules of thumb can be a useful tool if they are used as intended as the first step of a more detailed research process.
For example, the 25 times rule is certainly not the only tool you want to use when planning your retirement. However, if you are starting from scratch and have no idea where to even begin, the 25 times rule can quickly can you in the ballpark and help you understand how much money you will need by retirement.
Once you begin looking at the assumptions and limitations of the 25 times rule, it will lead you down a path of research and figuring out how to create a retirement plan tailored to your situation.
Remember the essential truth about any rule of thumb: It should be your starting point, never your ending point.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.