Comments on: Beware the Rules of Thumb

By: Shirley

Shirley — Sat, 31 Jul 2010 12:37:32 +0000

And you are also no longer paying work-related expenses such as daily commute cost or gas for the same, clothes, at work donations, bought lunches, quick to make dinners, etc. You may well spend the same amount of money on similar things, but you don’t absolutely have to. Little things really do add up!

By: Kosmo @ The Soap Boxers

Kosmo @ The Soap Boxers — Sat, 31 Jul 2010 03:59:36 +0000

I was wondering how long it would take for someone to mention this

By: Kosmo @ The Soap Boxers

Kosmo @ The Soap Boxers — Sat, 31 Jul 2010 03:57:33 +0000

These are two different concepts, though. With the accumulation of assets, taking the absolute value in favor of the relative one has a lot of merit. Bad Money Advice wrote about this a while ago.

However, accuracy is not a practice in accumulation – it is a measurement of how close something is to the correct result – RELATIVE to the correct result, you might say. Using a percentage standard of error makes the most sense – which is why polls quote margin of error as +- 2.3% rather than +- 5 voters.

To look at it another way:

You ask me to measure the long end of a 5 X 7 photo. I tell you it’s 10 inches.

I ask you to measure a 1 mile length of road. You tell me it is 5280.5 feet.

I’m off by “only” 3 inches – you’re off by 6. But surely you did the more accurate job of measuring. Relative is better than absolute in this case.

With regards to the rule of 72 – if you use it to determine how much money you’ll have at the end of a specific period of time (let’s say, 72 years), you’ll be much further off if you use the factor for 50% than the factor for 1%. The factor for 50% has a lower absolute error, but it compounds over time and over time eclipses the error for the 1% rate.

But, yeah, anyway it is supposed to be for quick mental calculations. If we’re getting bogged down in the error rate for one percentage versus the other, we’re really not using it as intended.

By: Darren

Darren — Fri, 30 Jul 2010 22:09:15 +0000

Good point regarding the rule of 72. I did a somewhat detailed post about this not too long ago that shows differences between the calculated amount of time to double, and the actual time it takes to double. For some of the stated interest rates, this difference can be quite large.

By: Nicole

Nicole — Fri, 30 Jul 2010 14:28:01 +0000

Heuristics are great if they get people to do something in the case where if they had to actually crunch the numbers they would do nothing. It is better to be close but not quite exactly right than to keep putting off the perfect decision so that no decision gets made at all. 120-your age in stocks is better than no money saved for retirement. 10% (or 15%) to retirement is better than nothing because you haven’t had time to figure out the exact number for your purposes (not that anybody knows the exact number anyway, even with the shiniest web calculator in the world).

In other words, heuristics are a great way to satisfice when trying to optimize would cause you to be paralyzed by the Paradox of Choice.

By: Kosmo @ The Soap Boxers

Kosmo @ The Soap Boxers — Fri, 30 Jul 2010 13:17:21 +0000

“(Incidentally, it’s obviously an estimate because if you have an interest rate of 100%, you don’t double it in 0.72 years, you double it in 1 year)”

That’s only true if you’re compounding annually, which is atypical.

Let’s assume quarterly compounding (which is also atypical):

After Q1: $125
After Q2: $156.25
After Q3: $195.3125
After Q4: $244.140625

Compound weekly or daily, and you double more quickly.

The Rule of 69 is actually more accurate, but 72 works better for “back of the envelope calculations”. It was always intended as an estimate, not as a replacement for a formal calculation.

By: Eddie

Eddie — Fri, 30 Jul 2010 00:25:40 +0000

Rules thumb are a great starting point. It gives an easily definable starting point, provides motivation, and a goal.If not successful for everyone over the long run, at least most of them are not harmful over the short run.

So long as a person is willing to move the goal posts as they gain education and experience, I say embrace it. Doing something is better then nothing….. the guy who saves 10% for retirement because he heard that was the rule may not be doing all he should…..but he’s better off than the guy who saves nothing!

By: Ron

Ron — Thu, 29 Jul 2010 18:17:38 +0000

You also stop saving for retirement after you retire. That’s 10% – 15% – 20%… oh, what’s that rule of thumb on savings again?

By: cubiclegeoff

cubiclegeoff — Thu, 29 Jul 2010 14:11:57 +0000

Good point. 72 is more fact than assumption.

By: cubiclegeoff

cubiclegeoff — Thu, 29 Jul 2010 14:08:08 +0000

Agreed. It depends on the situation, but often 10% is meaningless.

By: otipoby

otipoby — Thu, 29 Jul 2010 12:58:24 +0000

Interesting. I think considering % difference is more misleading than considering the actual difference.
I would rather have 1% off $200,000 (for example, buying a house) than 10% off $10,000 (for example, buying a car). I have read that humans think logarithmically (maybe a good blog post in the future). They will increase or decrease $1000 much easier when negotiating buying a house vs buying a car. In either case, $1000 is what matters.
My $0.02.

By: freeby50

freeby50 — Wed, 28 Jul 2010 20:22:16 +0000

The rule of 72 is basically mathematical fact (with a margin of error cause its an approximation).

Most of the other financial ‘rules of thumb’ are based on opinion, often make assumptions on the future or just use some semi-arbitrary choices. They should usually be taken with a grain of salt.

By: cdiver

cdiver — Wed, 28 Jul 2010 18:30:54 +0000

Well said Rob. Too many people think of this as the magical “Everything will be fine” number.

By: ian

ian — Wed, 28 Jul 2010 17:55:27 +0000

I have always interpreted it to mean 70% of Gross Income. What i think I earn now (my salary), in retirement I will only need 70%. Not because my expenses dropped but because I am no longer paying income tax.

By: knighthawk

knighthawk — Wed, 28 Jul 2010 17:21:52 +0000

Your calculations are misleading. Sure, being off by 3.2 months isn’t as long as 2.34 years, but percentage wise that’s 18.5% off for the 50% rate and 3.25% off for the 1% rate.