Smart SpendingSmart Spending

Beware the rules of thumb

They work pretty well in money matters, unless you need absolute certainty.

By Karen Datko Aug 10, 2010 8:50AM

This post comes from Jim Wang at partner blog Bargaineering.

 

The other day, I was explaining the Rule of 72 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 the interest rate.

At 10% a year, the rule says a balance doubles every 7.2 years. It's really slightly less than 7.275 years. At 5% a year, the rule says a balance doubles every 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 the money 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 one year.)

Should you have a percentage of your investments equal to 120 minus your age in the stock market? Which stock market? Domestic? Emerging markets? Small cap? Blue chips?

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

 

More from Bargaineering and MSN Money:

0Comments

DATA PROVIDERS

Copyright © 2014 Microsoft. All rights reserved.

Fundamental company data and historical chart data provided by Morningstar Inc. Real-time index quotes and delayed quotes supplied by Morningstar Inc. Quotes delayed by up to 15 minutes, except where indicated otherwise. Fund summary, fund performance and dividend data provided by Morningstar Inc. Analyst recommendations provided by Zacks Investment Research. StockScouter data provided by Verus Analytics. IPO data provided by Hoover's Inc. Index membership data provided by Morningstar Inc.

ABOUT SMART SPENDING

Smart Spending brings you the best money-saving tips from MSN Money and the rest of the Web. Join the conversation on Facebook and follow us on Twitter.

LATEST BLOG POSTS

Can you trust Carfax?

If you're thinking about buying a car and the Carfax report comes back clean, you're good to go, right? Um, maybe not. Here are four other ways you can avoid buying a clunker.

VIDEO ON MSN MONEY

TOOLS

More