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Beware the Rules of Thumb

Posted By Jim On 07/28/2010 @ 7:14 am In Personal Finance | 22 Comments

The other day, I was explaining the Rule of 72 [3] to my lovely wife. It’s a simple little mathematical trick that almost epitomizes the advantages and disadvantages of rules of thumb. If you want to know how long it takes to double a sum of money, divide 72 by its interest rate.

At 10% a year, the rule says a balance doubles ever 7.2 years. It’s really closer slightly less than 7.275 years. At 5% a year, the rule says a balance doubles ever 14.4 years. It’s closer to 14.21. It’s a pretty good rule of thumb and good when you have nothing on the line. If it makes a difference whether it doubles in 14.4 years or 14.21 years, then the rule fails. (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)

Should you have (120-Your Age [4])% of your investments in the stock market? Which stock market? Domestic? Emerging markets? Small cap? Blue chips?

Should you really be paying 30% of your income towards housing? Is this towards rent or a mortgage? Does it count utilities or is it just towards the mortgage or the rent bill? What about insurance?

As you can see, rules of thumb are good when you’re just talking about it around the room. They’re good for when there’s nothing on the line and you’re happy with a “good enough.” If you want to know with 100% certainty, you need to roll up your sleeves, grab a calculator, and do some work.

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[3] Rule of 72: http://www.bargaineering.com/articles/rule-of-72-understanding-compounding-interest.html