To manage your money properly, you must tread carefully around the minefield of prevalent investment myths. In this series, I try to debunk all such myths and misconceptions so that you can avoid jeopardizing your finances. In this article, I will talk about the common rules of thumb of personal finance and the dangers of following them blindly.
Rules of thumb are generalized tried and tested rules that can be used broadly for many different situations, in other words, it is “one size fits all” advice. Now by this very definition, it should be clear that such rules should not be used in the context of personal finance, as the keyword here is “Personal”. Since different people can never have the same set of identical requirements ever, the one size fits all advice will prove injurious for your financial health. Your financial decisions should always be personalized based on your risk profile, goals, current financial situations etc.
Now the question arises if financial planning thumb rules are so harmful, why are they so popular and why some so-called financial advisors or experts promote them? Well, the simple answer is that these are promoted as easy shortcuts to people who are already overwhelmed by personal finance decisions and who for some reason can’t or won’t take time for proper in-depth financial planning. In such cases, these rules of thumb are offered as readymade solutions for your financial needs, without understanding what those needs are in the first place. The end result is, you start abiding by these rules because you assume them to be sound advice since you stumble upon them so frequently.
However, that’s not true. These rules can cause more harm than good, as they do not take into account your unique circumstances and needs into consideration. These rules of thumb often provide oversimplified solutions which can harm your long term financial prospects, by underestimating or overestimating one’s savings, insurance, investment, retirement requirements.
Below are few such popular rules of thumbs which you need to be beware of as they are a classic example of how these rules don’t account for your personal needs :
- Save six months of expenses in an emergency fund
An adequate emergency fund is a cornerstone of your financial health, but this standardized rule of thumb does not take into the picture if you are a single earning member in your household or not, if you have a stable income or an irregular one, if you have a secured job or not. Basically, all the factors which help in understanding how much emergency fund is required by an individual are ignored. Blindly going for 6 months of expenses as the emergency fund can result in inadequate emergency fund corpus as having less or more than required funds here is dangerous for your financial well being.
- Life Insurance cover should be 10 times your annual salary
Finalizing the life insurance coverage based on multiple of income is a wrong practice. Your life insurance amount should depend on your specific needs like the amount of outstanding debts, future expenses, number of dependents, income replacement, etc. Ignoring all other factors except income can leave you underinsured, and cause difficulties for your surviving family members. Read my earlier post to find out how much insurance coverage you need here.
- Equity percentage in your portfolio should be your age subtracted from 100
If you’re 25, this rule suggests you should invest 75% of your money in stocks, and so on. I have written an entire post earlier explaining why investing according to age theory is baseless and misleading. Your portfolio allocation be it in debt or equity should be arrived at after taking into account your short term and long term goals, risk appetite, current financial situations, etc and not based on your age. Many people are not able to reach their financial goals because they keep aligning their assets allocation based on rule without figuring out if it is the right allocation for them or not.
- 10% of your income should be saved for retirement
Retirement corpus should be calculated based on life expectancy, good or bad health condition, inflation rate, expenses after retirement, etc and not on the previous salary. Keeping a fixed percentage as the savings rate for retirement throughout your earning life is not practical at all. This rule ignores the basic calculation of how much you may need in retirement. Also, it ignores fluctuations in your income and expenses level. Moreover, it overlooks how much amount you would have already saved, it just simply states that you should keep saving 10% of income.
Understand that there is no replacement for a properly made financial plan customized according to your goals and risk profile. Opting for so-called rules of thumb will give you a false sense of security and misguide you. For the complete well being of your finances don’t take any short cuts instead take an in-depth view of your financial situation for the best outcome.