I keep seeing old adages and rules of thumb popping up. I have made a note of some, but thought it might be fun to just share them as I come across them …
CAUTION – Rules of Thumb are an interpretation and generalisation of observation someone has made. They are not gospel and should not be be just applied. They mainly exist to allow a simplification of often complex data to a simpler statement to help us understand a picture – not paint it.
These do not constitute advise of any kind – you are the master of your own destiny
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Property
- 1% rule – monthly rent should be at least 1% of the cost of the property – This comes from a USA site on property and really just emphasises that a decent positive cash flow should come from a decision to purchase and rent out. In essence though it says aim for a gross yield of at least 12%.. quite high in normal rental markets.
- 50% Expense rule – net expenses (exc mortgage) should not be more than 50% of the gross income – again from the USA and has some sense – it is no good not making a post cost return, so just about reminding a landlord that they need to fully factor costs in
- 70% rule – purchase of a property for doing up + costs of works should not be more than 70% of the estimated resale value – reminder to factor in a decent profit .. sort of self evident really, but amazing how many people do not consider resale price, costs and fail to make a decent return
- Rent vs purchase – price to rent ratio (>20 better to rent; <15 better to buy) – really more about the cost of money (as in a loan) when you think about it
Saving
- Penny Approximation – Stacking Benjamins says every £100 you don’t spend is 1p per day for ever income (approx 4%). Say I buy coffee & cake when travelling and spend £500 a year. That is the equivalent of an income of nearly £19 a year forever if I saved/invested that £500. Lets say I do this for 20 years with no interest compounding, I end up with a fund of around £11,000 and a 4% income is £400 every year forever…. the very real point is about lifestyle choice and being an ‘active’ saver rather than me-too consumer. It does not take a lot of small changes to our consumption and spending habits to really add up … I do like this !!!
- Each £1 saved is worth £2.50 in 10 years after tax – mmmhhh another USA claim and just running numbers is wildly wrong. The assumption is a tax rate of 33% so that £1 would have to compound at 16% pa … rubbish….. so why post this…. to demonstrate that some posted RoT really are dangerous and always, always, always do a calculation to sanitise
In some respects this is similar to the Wealth Barber adage of “A penny saved is two pennies earned.” Again the maths does not quite stack as its more like 1.3p after US tax and 1.4 after UK tax, but a far better point that making a saving (actually, or by not doing a purchase) can have a greater impact on long term wealth than getting a pay rise
- 48 Hour Rule – This thumb rule is useful against impulse purchases. The rule states that when you have a strong urge to make an impulse purchase then postpone the purchase for 48 hours.
Remember – most advertisement is about mind manipulation and that has an immediacy to it. It is why (in the UK), credit purchase has a 1-2 week cool off period
- 10% pay rise rule – each time you get a pay rise or bonus, use 10% for a lifestyle creep and 90% put into wealth savings for retirement
- 1% windfall rule – spend 1% of a windfall and put 90% away for at least 6 months to cool off
- Saving 10% of income – Financial guru Liz Weston says that if you’re young, you should follow this guideline: “Save 10% for basics, 15% for comfort, 20% to escape.
The basis for this is unclear, but I just run some numbers and assume someone starts at the age of 20 with a salary of £25K, an effective tax rate of 20%, an annual salary increase of 3% and savings rate of 5% at the age of 60, a 4% withdrawal rate would yield (in terms of after tax salary), 25%, 37% and 49% of final salary for 10%,15% and 20% saving. Clearly saving rates could go up as costs (such as a mortgage paid off) so not hard to see how a 20% rate could get close to final income .. comfort and 10% a rather more modest basic level…. very broad brush… save at least 10% and as close to 20% as you can (or more) seems to be the general principle.
Investing
- Rule of 72 – take an interest rate and divide into 72 and that is a close approximation to doable capital. If you look at the actual (log(2)/log(interest rate), and plot you get a min (zero error) around 7.85%. By 20% is 5.3% out and 2% its around 3% out… so for a practical sense, its a good approximation for rates up to 15%.
This works backwards too so you could get a decent approximation of purchase power in a number of years
- Rule of 114 (triple) and rule of 144 (quadrupole) – compute as per Rule of 72. Error rates to actuals a bit more different but still a decent approximation
Note that you can adapt this to any multiple with a little adjustment, so for example the time to 50% is ‘rule of 41’
- If you don’t understand it, don’t buy it – best advise I have seen … if you make an investment without having a pretty decent understanding of that holding you are a gambler [Are you an Investor or a Gambler ?]
- Be comfortable with being uncomfortable – really about not panicking on a drop. Have a decent risk tolerance and remember that the very longest bear in 120 years was only 29 months and was fully recovered 3 years later…. know, understand and stick to your Risk Tolerance plan
- 120-age Stock-Bond allocation – doing the sums, at 40, 50, 60,70 and 80 you get 80%,70%, 60%, 50% and 40% for Equity allocation and the rest in Bonds.
In a sense, its a balance around the all 60-40 split of equity and bond at a nominal retirement point. Personally, I think it rather depends on where in an economic cycle you are. For example, after the 2008-9 financial crash stocks lost 50% of their value. Historically in every case the recovery has been between 2-3 times that, so the equity risk one could argue is substantially reduced after a bottom out and the upside rapid, high and highly probably… having 40, 50 or 60% bonds makes no real sense (unless all you want is a very solid income stream with limited risk)
- Net worth at age should be Gross Income * Age/10 – I do not see any reasoning for this. For example, a salary at 60 years old of £50k would lead us to conclude a Net Worth of £300K was needed… pretty low for retiring. Even at a 4% drawdown that is only £12K pa
Another one where doing the sums and just asking if it makes sense is needed …. even ‘Age/5’ would be low and also what is ‘Net Worth’… really should be about Free Cash, ie what you can convert to actual income
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- FI (Financial Independence) when funds equal 25 x Bills & Expenses – in a sense this is a variation on the 4% maxim, but crucially, it is FI and not FIRE (the Retire Early is missing). This is a guestimate point of when you may have sufficient to draw an income to support a different and more relaxed way of life which may very well be before you can afford to retire properly. 4% is a common US rate, but the UK has lower returns so a 30X or more may be better (ie around 3% assumed return).
Just consider for example one ‘bill item’, that of a mortgage. My mortgage costs me around £10K pa to pay down. at 30x that means I would have to have £300K more in funds to equate to the FI point. I could pay it off with £70K. Just considering bills and expenses and look at the impact of expenditure on the size of funds needed to cover. Really, this is the point of this FI RoT: consider when !
Retirement
- 4% rule – this is really a USA invention based on some published research. Fundamentally it says you can draw out of your funds starting at 4% a year rising with inflation and have a 95% confidence of not running out of money in 30 years.
There are many caveats and alternate adjustments based on annual growth of funds, but it should be noted this is USA thing and the USA has historically higher rates of return than the UK. a UK initial rate of between 3.0% and 3.3% has been suggested as more applicable. Also some evidence that using 2.5% anywhere pretty much means you never run out of money … so aim for 40X your spend needs and bob’s your uncle !
Miscellaneous
- Government Guidance – The UK Government has published this guidance as it very dryly attempts to provide a framework for stating Rules of Thumb or ‘Nudges’ …. fascinating stuff and some excellent points about not taking things too literally