Beware of Rules of Thumb and Words of Wisdom

There are many financial rules of thumb and words of wisdom out there.  However, applying them to your situation can be problematic because they are not customized to your particular circumstances, they usually do not address several other important variables, and they can lead to a false sense of security.

Consider the 60/20/20 rule of thumb regarding budgeting.  Which states that, among your after-tax income, you should allocate about 60% toward your essential expenses, 20% toward discretionary expenses, and 20% toward retirement investing.  Obviously, not enough variables are considered by this 60/20/20 rule of thumb to determine whether you'd be financially secure following this strategy alone.

For example, imagine two different people in their late 30's, both the sole income earners for their family of four, not yet financially independent, earning the same income, both following the 60/20/20 rule of thumb.  One of them has adequate long-term disability insurance and life insurance policies in place, paying premiums each month for these policies, and categorizing these premiums as part of their essential expenses.  The other has no long-term disability insurance or life insurance policies, instead spending more on food, housing expenses, and so on.

Both people spend 60% of their after-tax income on essential expenses.  In the event of a long-term disability or sudden death, one person has enough money each month to keep food on the table for their family, keep a roof over their heads, and continue to invest for their retirement.  The other person would be financially devastated, with no money coming in each month to use for food, housing expenses, or retirement investments.

Now, let's assume both people remained healthy and worked until age 65 following the 60/20/20 rule of thumb.  Can we say that because they both invested 20% of their after-tax income toward their retirement during their working years, they're both going to be in good financial shape?  Of course not.

What was each person's average annual pre-tax rate of return on their retirement investments?

If one person averaged 3% while the other averaged 9%, the size of their retirement nest eggs would be dramatically different at age 65, all else equal.  There are several other important variables beyond those mentioned above which would have an impact on one's retirement security.

People often follow rules of thumb and words of wisdom in other contexts as well.

Like someone taking the phrase "an apple a day keeps the doctor away" and believing they will remain healthy and live a long life if they simply follow this strategy.

What about the rest of their diet?  How many hours per week do they exercise?  What's their BMI?  Do they smoke?  Any family history?  Do they see a primary care physician every year?

There are many other important variables involved in predicting someone's physical health over the long run beyond whether or not they eat an apple a day.

Many people avoid seeing physicians and financial advisors, instead self-diagnosing themselves as "healthy as a horse" or "all set," perhaps because they are asymptomatic and follow a few simple rules of thumb or words of wisdom.  However, they may not get a clean bill of health from a trained professional, whether we're talking about their physical health or their financial health.  In both contexts, diagnosing and managing problems early on, when your options are better, is almost always in your best interests.

If you are a prospective client and would like to learn more about hiring us for a financial consultation, where, among other things, we would identify any potential problems with your financial planning efforts to date, please visit our Schedule Meeting page.



Mike McErlane, DO, MBA, CFP^®, CFA^®, RICP^®, EA, MCEP^®

Mike McErlane is the owner and founder of Comprehensive Financial Planning for Doctors, LLC based in Frisco, Texas.

Comprehensive Financial Planning for Doctors, LLC (CFPFD) is an Investment Adviser registered with the Texas State Securities Board.  Registration of an Investment Adviser does not imply any specific level of skill or training.  CFPFD only transacts business in states or jurisdictions in which it is registered or exempt from registration.  A copy of CFPFD's current disclosure brochure is available through the Securities and Exchange Commission's Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov.

The opinions and analyses described are subject to change at any time without notice.  Any information is considered general and is not intended to provide any specific advice or recommendations.  Your use of the information is at your sole risk.  You should consult with your financial advisor, attorney, tax advisor, insurance agent, or other professional advisor before taking action on any information or implementing any strategy.