How Rules Of Thumb Can Help

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How Rules Of Thumb Can Help
Rules of thumb help you make quick financial decsions without sacrificing a decent outcome
Larissa Fernand - 31 August 2022

A friend of mine just started earning a few years ago. All her money lies in a savings account and two fixed deposits (FDs). When I asked her why all her money is with the bank and why she has failed to invest, her candid reply was very revealing: “I don’t know how much to save. I don’t know how much to invest. I don’t know where to invest. I don’t know where to start. But I know I am wasting time, so then I panic. And I put it in an FD, so at least it earns something.”

It is not that she did not have the inclination to invest. It was not that she did not have the means. It was a simple case of choice avoidance and decision paralysis. When faced with too many options, the result can be paralysing. Couple that with being pushed outside her comfort zone and area of expertise. Choosing a mobile phone does not tire her out, but deciding where to deploy her money leaves her with decision fatigue and unhappiness.

In such a situation, a simple guideline is the most appealing and practical. Such guidelines are often referred to as financial “rules of thumbs”, and they help individuals cut through the fog. It takes the complex world of finance and makes it simple and doable.

Rules Of Thumb: Help Overcome Psychological Barriers

They are financial short-cuts that lessen the psychological pressure in the decision-making process because they are easy to follow and reduce choice complexity. They help you make a decision without overwhelming your mental or emotional capacity.

Rules of thumb help you make quick financial decisions without sacrificing a decent outcome. By getting you started, it helps overcome the psychological barrier. Once you get going, you will ride the momentum and gain more confidence.

Years ago, an experiment was conducted by Alejandro Drexler of the Federal Reserve Bank of Chicago, Greg Fischer of LSE, and Antoinette Schoar of MIT.

They introduced two financial literacy training programmes for small business owners in the Dominican Republic. One was the standard accounting programme, and the other was the rule-of-thumb training. For example, the standard accounting trainings taught participants to separate their business and personal accounts by instructing them how to calculate business profits based on a typical accounting curriculum for micro-entrepreneurs. The rule-of-thumb training gave them a physical rule to keep their money in two separate drawers (or purses) and to only transfer money from one drawer to the other with an explicit “IOU” note between the business and the household. At the end of the month, they could then count how much money was in the business drawer and know what their profits were.

An evaluation noted that individuals who were offered rule-of-thumb-based training showed significant improvements in the way they managed their finances and in the accuracy and internal consistency of the numbers they reported. They were more likely to keep accounting records, calculate monthly revenues, and separate their books for the business and the home.

A big part of the reason was that the rules of thumb were memorable, general, and flexible. The simpler rule-of-thumb training was a better fit for less financially sophisticated individuals—a big lesson for us there.

Rules Of Thumb: Help Overcome Practical Barriers

Personal finance must be personalised to your situation. You will get the most optimal result if you follow that. But that can be the next step.

If you are just getting started in the world of investing and facing an overwhelming number of options, unpredictable uncertainty, time pressure, and lack the expertise, a financial rule of thumb can help you make an efficient and effective decision.

Rules of thumb are practical. They are not perfect. They are not the most optimal. But they will suffice to get you going. Once you start, you can gradually build in more complex and nuanced reasoning. For example, the 100-minus-your-age rule for equity allocation. This rule provides you with instant asset allocation. So if you are 30 years of age, you should hold 70 per cent of your portfolio in equity (100-30=70) and the rest in fixed income. If you are 70, the equity allocation will drop to 30 per cent (100-70=30).

This rule has helped simplify asset allocation. But it was conceptualised at a time when bond returns were much higher. Also, life expectancy has increased. So while it is great to get started, you would need to tweak it later based on your situation. What are you saving for? When do you need the money? How many dependents do you have? What is your cash flow? How many loans are you servicing? Where does your spouse invest? Do you have an emergency fund in place? Are you planning to retire early?

But if you never had this rule, you might not have invested in equity at all. Or swung to the other extreme and invested only in equity. These rules are excellent benchmarks. Use them as a foundation upon which you can build a portfolio and create wealth.

Such rules also help in commitment and build consistency. For instance, the 10 per cent savings rule, which requires you to save 10 per cent of your income towards retirement. This amount is far from realistic. But it makes you committed to saving. It gives you focus. And it gives you a benchmark.

When I began saving, I could save just 5 per cent of my income. But I kept the 10 per cent figure as a goal post. It gave me tremendous focus. Eventually, I was able to cross the 10 per cent saving goal figure, but if I had not kept it in front of me, I might not have gotten there. Or have taken a very long time to do so. The simplicity and practicality of this rule is what got me on track and kept me there.

The rules of thumb are not written in stone. They are benchmarks that serve as guideposts. They are personal commitments that help us prioritise what is important. They nudge us in the right direction.

They also help set boundaries in place. For example, the 30 per cent debt-to-income ratio rule. This compares how much you owe each month to how much you earn. It is a metric that reveals the percentage of your gross monthly income (before taxes) that goes towards debt payments (home loan, credit card debt, personal loan, car loan, any other loans). This level indicates that your debt is at a manageable level. Here again, the right figure will depend on your situation, but this can be used as a safeguard so that you do not exceed the debt you are taking on.

Rules Of Thumb. They Help You Work With Your Brain

To cope with the tremendous amount of information we encounter and to speed up the decision-making process, our brains rely on shortcuts to simplify things. Or else, we’ll have to spend endless hours analysing everything, all the time.

Our brains use shortcuts. It’s how we are wired and the reason that we accomplish so much! So we need to work alongside our brains rather than against them. Rules of thumb do that because they take the complex and distil it down to the very simple.

That is why I believe that rules of thumb are the best way to start your financial journey.

To go back to my friend, she got started by putting 12 per cent of her salary credited into her account into an index fund every month via a systematic investment plan (SIP).

The author is an Investment Specialist at Morningstar India

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