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Carla Fried: Sometimes, in personal finance, simple actually works

Carla Fried, Rate.com on

Published in Home and Consumer News

When it comes to making financially smart decisions, saving and investing experts are typically quick to tell us that only rubes rely on rules of thumb.

Finance pros are often dismissive of anything but a refined approach that is focused on delivering optimal outcomes. (Which, not coincidentally, plays into their career advancement/compensation.)

And yet that attitude creates its own risk: that we all become so cowed or overwhelmed by all the details of advanced theories and strategies that we end up letting the pursuit of the perfect be the enemy of the good: We freeze up and do nothing.

Thumbs up for rules of thumb

But as a recent report from Morningstar lays out, academic research has found that sometimes, simple financial rules of thumb can, in certain situations, work out just fine.

Morningstar itself set out to take a dive into researching what sort of financial rules of thumb are popular and, more importantly, which ones might be effective.

Popular financial rules of thumb

Nearly 900 study participants were presented with a series of financial rules across four broad categories and asked which ones they used the most.

—Debt management: Both “pay more than the minimum payment” and “always pay debt in full when possible” were used by 67% of participants.

—Spending: 72% used “don’t spend more than you make,” followed closely by “make list for shopping” at 71%.

—Saving: Both “save as much as you can” and “separate your saving and spending accounts” were used by 69% of participants.

—Investing: Diversifying your assets was the most popular rule of thumb, at 63%, followed by “invest in line with your risk tolerance” at 62%.

Financial rules of thumb that seem to work

The study participants were also asked a series of questions that enabled the researchers to assess their general level of financial well-being, based on the Financial Well-Being Scale developed by the Consumer Financial Protection Bureau (CFPB).

 

The CFPB Financial Well-Being scale requires participants to rate, on a five-point scale ranging from “completely” to “not at all,” their personal assessment of 10 statements including “I am getting by financially,” “I could handle a major unexpected expense” and “My finances control my life.”

The researchers then looked to see which rules of thumb had the highest correlation to financial well-being. Interestingly, they were not necessarily the most popular rules of thumb.

The five rules with the strongest relationship to financial well-being:

—Always pay debt in full when possible.

—Save at least 10% to 30% of your income a month.

—Invest in line with your risk tolerance.

—Don’t spend more than you make.

—Have an emergency fund to cover three to six months of living expenses.

The researchers are careful to point out that this is just a correlation; more research is needed to understand the extent to which a given rule of thumb actually causes one’s financial well-being to be higher. But there’s no arguing that if you follow through on those rules of thumb you’d likely be feeling pretty darn good about your finances.

Be specific, and make it as easy as possible

The researchers turned up a few examples where well-intentioned but vague rules of thumb were more associated with people who scored low on the well-being index. The rule of thumb “try to find extra ways to earn money” had the worst negative correlation with financial well-being, and “pay yourself first” also fell sorta flat. That might suggest that the less specific a rule of thumb is, the harder it is to put into action.

To that end, the more tenacity and willpower you need to exert to keep at a rule of thumb, the harder it will be to stick with it. The good news is that so much of your financial life can be automated. Whether it’s auto-bill pay, automated bank transfers from your checking account into a designated savings account, and automated contributions to retirement accounts (through work or your own IRA), technology is standing by ready to help you make a habit of the financial moves that can build financial security.

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