10 wives' tales masquerading as rules of thumb
If you believe some of these oft-repeated financial tips, you may also believe that a watermelon will grow in your stomach if you swallow a seed.
It's been said that if the palm of your right hand itches, you'll soon be coming into money. On the other hand (seriously, no pun intended) it's also been said that if your left palm itches you'll soon be paying out money.
Don't laugh. There are folks out there who actually believe this stuff.
Of course, I'd expect such confusion emanating from what is essentially nothing more than an old wives' tale.
Beware of financial rules of thumb
If you ask me, a surprisingly large number of financial rules of thumb are actually nothing more than gussied-up old wives' tales too. In fact, they're almost as crazy as those itchy palm notions.
That's not to say that all financial rules of thumb are completely bogus, but some are more dubious than others because they are often based on misguided conventional wisdom or generalized ratios that are intended to work for the average person. As such, they should always be taken with a generous serving of salt. To prove it, here are a few examples:
1. Red cars are more expensive to insure.
If you buy this, you may also believe: If three people are photographed together, the one in the middle will die first.
Reality check: How much you pay for your insurance has absolutely nothing to do with the color of your car. However, it does depend on the car you drive, your age, and your driving record.
2. Buying a home is always better than renting.
If you buy this, you may also believe: It's bad luck to leave shoes upside down.
Reality check: During the last real estate run-up, this mantra was repeated ad nauseam. The truth is, sometimes paying rent may make a lot of sense. In exchange for that rent payment, you're getting a place to live without all the commitment and additional costs that come with owning a home. For a lot of people, the added responsibility is more hassle than it's worth. Post continues after video.
3. Avoid adjustable-rate mortgages like the plague.
If you buy this, you may also believe: If you swallow a watermelon seed, a watermelon will grow in your stomach.
Reality check: If you are absolutely positive that you will be living in your house for only a short period of time, an adjustable-rate mortgage may save you a significant amount of money -- even when rates are rising. This is especially true for hybrid ARMs where the loan's interest rate may remain fixed for, say, three or five years before readjusting.
4. When planning for retirement, assume annual stock market returns of 8%.
If you buy this, you may also believe: A cow lifting its tail is a sure sign that rain is coming. (Well, it's a sure sign something's coming.)
Reality check: Between 1981 and 1998, when the stock market was averaging annual returns of almost 13%, this figure seemed conservative. Since then, the stock market has seen the bursting of the dot-com bubble, followed by a second crash in 2008. According to some experts, the stock market can now be expected to return only 4.5% annually, based upon current valuations.
5. To determine the percentage of stocks you should have in your portfolio, subtract your age from 100.
If you buy this, you may also believe: Placing a bed facing north and south brings misfortune.
Reality check: According to CNNMoney.com, because of longer life expectancies, this number may not be aggressive enough. Instead they recommend subtracting your age from 110, or even 120.
6. Never buy a house that costs more than three times your annual income.
If you buy this, you may also believe: Any ship that sails on Friday will have bad luck.
Reality check: When I bought my last house in 1997, I paid roughly four times my annual income. It was tough for a while, but not impossible by any stretch. A broader, but much better, benchmark to follow is to make sure the ratio of all your monthly debt payments to your gross monthly income does not exceed 36%.
7. You should close any credit accounts you no longer use.
If you buy this, you may also believe: Dreaming of a lizard is a sure sign that you have a secret enemy.
Reality check: Credit card companies see long-held accounts -- especially those lacking negative reports -- as proof of credit responsibility. Because a portion of your credit score is determined by your borrowing history, as well as the ratio between the balances on those cards and your total available credit, it's often wiser to keep your unused credit accounts open.
8. When planning for retirement, anticipate replacing 80% of your preretirement income.
If you buy this, you may also believe: The spouse who falls asleep first on their wedding day will also be the first to die.
Reality check: The problem with this rule of thumb is that it assumes expenses will stay the same in retirement, when for most people nothing could be further from the truth. For example, kids move away, people may pay off their mortgage and/or downsize to a smaller home. The truth is, for many reasons many people will spend far less in retirement than they do in their working years.
9. To quickly figure a server's tip, double the first digit of the bill's total. If the bill is $100 or more, double the first two digits.
If you buy this, you may also believe: If you say goodbye to a friend on a bridge, you'll never see each other again.
Reality check: The standard tip for good restaurant service has been 15% for decades. Well, that is until tip inflation once again reared its ugly head. If you're not careful, following this rule could result in an overly generous tip.
10. Your minimum net worth at any given age should be your age multiplied by your pretax annual income, with the result divided by 10.
If you buy this, you may also believe: Salty soup is a sign that the cook is in love.
Reality check: Never mind that this formula has many flaws. Net worth is just a snapshot in time that serves very little purpose, unless you plan on liquidating all your assets. In fact, in the grand scheme of things, the annual change in one's net worth is a much more important indicator of financial health. Yes, folks, even more important than an itchy palm.
I'm amazed how many people have chaotic financial life.
Never, never, never use credit. Pay off debt, cut up & close all credit cards.
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