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Financial Rules-of-Thumb

by Tim Isbell, August 2014

(#finance, #investing)

Here is a collection of nuggets of financial wisdom. I didn't create them, but I've used them long enough to share them with you. They are not actually "rules" - they are more in the category of good advice. So don't apply them rigidly but receive them as guidelines and starting points in your financial life. I've placed them in the sequence that most of us need them - from the beginning of our working life and into retirement.

Recently I noticed that about 50% of the visitors to this site are under 35 years old. When I asked one to look over this webpage and tell me what financial questions it brings to mind, the response surprised me:

  1. What is a stock and what is a bond? 
  2. How do I get started understanding investments? 

Apparently it's time to think about writing a primer for investing, particularly for young adults. In the meantime, if the above two questions are also on your mind, you can find answers to the first one in the Glossary (along with explanations of several other terms). And you will find a good starting point for the second one in Investments. Also, I'd love to receive your personal finance questions. They will focus my thinking on your needs/interests for future posts. You can reach me through Contact Tim (or if you know my direct email address, just send it there).

Ok, here's my list of Financial Rules-of-Thumb:

Student Loan Rule

  • Limit student loans to the starting annual pay for the career that fits the degree.

This "rule" assumes the student enters a career with enough discretionary income to apply 10% per year to the debt, which generally will pay off the debt in 10 years. But this obviously depends on your employment over those ten years. So I recommend limiting debt to that which we think we can reasonably pay off in 5-10 years, from the expected pay our education provides. Anything beyond this is likely to collide with the costs of raising kids, increased housing needs, our kids' college expenses, and our retirement savings. Changing majors extends the time and cost education even further. So be careful not to take out your full quota of debt until you are pretty confident you have chosen the right major.

25 Times Rule 

This rule is to guide our savings plan, in preparation for retirement.

  • (Number of dollars/year we expect to spend from a portfolio) * 25 = (Size of the portfolio we need)

I've placed this rule first in the list because it's important to know early what our financial goal is at the end of our career. If we delay the start of our savings/investment program, we'll have to save at a much higher rate later in our career.

So, this rule provides a first estimate of how much of a portfolio we will need when we retire, to maintain our pre-retirement standard of living. Let's say we figure that we'll need to supplement Social Security with extra income of $30k/year. Then before we retire, we'll need to build up an investment portfolio of about 25 * $30k = $750k. For the details on this, see Retirement Funding and browse down that page to the section: "So how much money do I need to accumulate in these stashes?"

Emergency Fund Rule 

  • Build an emergency fund that covers as many months as the current unemployment rate. 

The most common emergency fund rule is to set aside enough for 3 to 6 months living expenses. But I ran across this version that makes more sense to me because it connects to the unemployment rate. So, if the unemployment rate is 8%, build a fund with enough in it to last eight months.

10-10 Rule

  • Donate 10% of income to charity and invest another 10% for long-term needs. 

The conventional wisdom is a 15% rule, meaning to save and invest 15% of our income from the beginning of our career for long term needs. My advice is a little different, primarily because I'm a Christian and a proponent of 10% tithing

Keep in mind that generating $30k/year in retirement to supplement Social Security requires us to accumulate about $750k in investments (see the 25 Times Rule, above). If we don't start building this fund until we are 35 years old, the percentage we must save every month goes up quickly. So, we need to learn to live on no more than 80% of our income, and we need to invest wisely.

Those who follow this 10-10 rule will be glad they did - throughout life, not just at retirement time.

Rule of 72 

  • (Number of years to double an investment) * (% growth rate of investment) = 72

Here's a very close approximation for how long it takes a 5% return to double a portfolio: 72/5 = 14.4 years. Or if we want to know what return it takes to double in 10 years, we can find it this way: 72/10 = 7.2 years. To convert this to tripling our money, use 115 instead of 72.

  • (Fair price/earnings ratio) = 20 - (inflation)

"Trailing P/E" is the price of the stock today divided by its earnings for the past year. If inflation is running 3%, then a proper trailing P/E ratio is 17. 

Conventional wisdom is that a stock with a much lower P/E than this is under-priced (cheap) and likely to rise, and one with a much higher P/E is overpriced (expensive) and likely to fall. This rule not only applies to individual stocks, but it also works for mutual funds and industry indexes. There are variations to this rule. For example sometimes we'll see a "Leading P/E," which is today's price divided by the anticipated earnings in the next 12 months. Another one: William Bernstein (and many others) refer to the Gordon Equation (see Glossary: Gordon Rule) as a way to assess the fair market price of a stock or market.

I am in the camp with those who resist timing the markets. So I pay little attention to stock price assessment rules-of-thumb. But if we read much personal finance literature it's good to know what these terms mean.

  • (% of stocks in our portfolio) = 110 - (our age)

If I am 50 years old, this rule recommends that my portfolio contains 110 - 50 = 60% in stocks, and the rest in bonds (40%). It offers a first good approximation - at least during our working career and into early retirement. For a more thorough treatment see Asset Allocation Basics and its associated links. Sometimes we see a more conservative version of this rule, where the 110 is replaced by 100. 

Retirement before kids college

There is broad agreement among experts that saving for retirement is higher priority than saving for our kids' college fund.

Why? Because kids can borrow money for college; but parents cannot borrow money for retirement. So unless we expect/want our kids to be our retirement strategy, we need to prioritize retirement savings at the top of the list.

This is a rule for acceptable spending levels once in retirement. It is essentially a restatement of the Rule of 25 (see above).
  • (Number of dollars we can spend in the first year of retirement) = 0.04 * (Size of our portfolio)

This rule estimates how much we can safely spend the first year in retirement, and presumes that we can safely increase the number in future years by the rate of inflation. If we have a portfolio of $750k when we enter retirement, this rule says we can spend 0.04 * 750k = $30k the first year. This rule is not a sure bet but is a good place to start. See Retirement Funding for a more thorough treatment of retirement spending.

Since the Great Recession of 2008 and the subsequent spectacular rise in investments, many personal finance professionals expect lower than historical returns for the next several years. I tend to agree with them. Such writers recommend a more conservative annual withdrawal number of 3.5 or 3%.

So, there they are - my financial Rules-of-Thumb.

All the best,


(Edited with Grammarly)

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