Do rules of thumb lead to burnt fingers?

While financial rules of thumb offer a convenient starting point for the undisciplined, they often collapse under the weight of unique life circumstances and market volatility.

This is a monthly column in Mint by Priya Sunder, Director and Co-founder of PeakAlpha.

My friend is a professor of Economics in the country’s leading business school. He loves his job, yet choosing his profession was not easy. He studied science and mathematics in high school and prepared for the IIT exams, as did many of his classmates. Friends and family coerced him into studying engineering.

It was a safe career choice, they opined, with salaries 20% higher than the market, and jobs almost guaranteed. My friend was miserable because his interests lay in advancing our market’s competitiveness through monetary policy rather than testing a capacitor’s role in maintaining voltage.

My friend did listen to his heart in the end, after five wasted years of pursuing a stream that satisfied others’ desires, not his.

His example got me thinking about the choices we make about money. Are we doing what is right for us, or are we following the herd? Is the noise around us drowning out the right decisions we ought to make with our money? Are our decisions based on logic, or general thumb rules and simplistic probabilities about risk and return?

I often wonder whether simplifying the decision-making process is useful or detrimental to personal finance. My clients frequently ask me these questions during our conversations.

“Shouldn’t we use the 50-30-20 income rule to plan for needs, wants and savings? Why are we not applying the 4% withdrawal rate for retirement planning? Why is ten times my income not enough to meet my life insurance requirements? Why are you recommending a lesser equity allocation when 100 minus age is the right balance?”

Personal finance is just that—personal.

Good financial decisions are those that analyse one’s specific life situation, based on data and objectivity, and that steer clear of behavioural biases, gut instincts, or heuristics. For example, the 50-30-20 rule for apportioning income between needs, wants, and savings is too simplistic for someone who has just started working in a metro area, where the cost of living is higher than in her rural hometown. Hence, a large part of the salary in the early years of work may go towards basic necessities such as rent and living expenses, leaving little for wants or savings.

But that is not necessarily a bad choice because when someone is young, even a 5-10% savings rate can compound exponentially since the number of working years is higher.

A 4% retirement drawdown rate may fail for someone whose corpus has eroded midway through retirement due to a sudden, large outflow for an unplanned expense. It may not work for someone who would prefer to consume her assets during her lifetime rather than bequeath an estate.

The drawdown rule may not work when the first few years of retirement coincide with a steep market correction, as sequential risk can erode the value of the retirement corpus. Also, if one retires early or lives beyond a 30-year retirement period, the 4% rule may cause the portfolio to deplete before the end of one’s lifetime.

Similarly, insurance requirements for individuals or families constantly change depending on assets built or liabilities incurred. For someone who is the sole earning member of the family, and with large liabilities and future obligations, an insurance cover of ten times her income may prove insufficient. On the other hand, a 10x cover would be excessive if one’s family is financially secure and assets are sufficient to fund all future expenses.

Often, such thumb rules prove inappropriate for someone’s specific circumstances. Yet, in certain circumstances, heuristics or gut instincts can prove useful, especially when we need to make quick decisions, when information is insufficient, or when the decision-making process is complex and a simple rule of thumb is the most convenient solution.

In the recent India-New Zealand World Cup cricket finals, the Indian captain Suryakumar Yadav made a quick decision to bring in spin bowler Axar Patel after a particularly expensive over by Hardik Pandya in the powerplay. Patel then successfully dismissed an established batter, Tim Seifert. Yadav employed a common cricketing thumb rule in that critical moment. Often on a hard pitch, when a batsman is comfortable with the pace, bringing in a spin bowler can introduce variation that can break a batting partnership.

Sometimes, such quick decision-making tools work best when a better decision-making framework is unavailable. If Yadav had to use data to decide on the field that day, he would need to compute the ball’s trajectory, or the angle of the swing needed to claim a successful wicket. Instincts and intuition can sometimes be the best decision-making tools because they draw on resources available at a given point in time and help prevent us from overanalysing data.

However, when it comes to comprehensive financial planning, robust data is critical for determining investment strategies, asset allocation, risk, returns, income-expense patterns, assets, and liabilities. Such decisions are best suited to more analytical and less heuristic-driven strategies.

In the absence of data and resources to analyse it, it may be worthwhile to deploy heuristics, but only as a fallback. For example, in the absence of a proper financial plan, the 50-30-20 rule towards needs-wants-savings will provide people with some degree of financial prudence compared to no discipline at all.

The Bollywood blockbuster, Three Idiots, criticizes herd mentality regarding career choices. The movie was shot in the same business school where my friend teaches. The character in the movie—Farhan—studies engineering only because his father wants him to, even though Farhan’s passion lies in wildlife photography. Farhan and my friend’s stories are similar—in both the beginning and ending. The ending is a happy one because both ultimately ignored the noise around them and did what was right just for them.

Investing is no different.