Rule Of Thumb: Definition, Working, Importance, And More
The rule of thumb is a general rule that helps people as a guide in investments. For example, a rule of thumb in life is to save five to ten percent of your income for emergencies. The phrase owes its origins to the application and usefulness of thumbs in general. It is a heuristic guideline with the help of which you can stick to a basic set of rules regarding a particular subject or a course of action.
In this article, you will learn about the rule of thumb and how it works for investors and businesses. Next up, we will also take a look at some examples of “rule of thumb” in finance. Furthermore, we will discuss the importance of the “rule of thumb” method in daily life or businesses. Hence, to learn more, read on through to the end of the article.
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What Is The Rule Of Thumb?
According to Investopedia,
“A rule of thumb is a heuristic guideline that provides simplified advice or some basic rule-set regarding a particular subject or course of action. It is a general principle that gives practical instructions for accomplishing or approaching a certain task. Typically, rules of thumb develop as a result of practice and experience rather than through scientific research or a theoretical foundation.”
In general, the rule of thumb is a piece of informal advice that is often practical. Basically, it provides simple rules of what applies to a particular thing or outcome in most situations. There are many rules of thumb in finance that give us an idea of how to save, how to invest, how much to pay, and many more.
However, the “rule of thumb” is not scientific in nature. It offers advice about what would be the most practical and general thing to do in a given situation. Furthermore, this rule also does not take into account the needs and demands of a person. Hence, just because it applies to someone’s situation, it does not apply to someone else.
Rules of thumb develop out of experiences and practices. Hence, people use it to stay safe in most cases. Historically, in the 17th century, traders used to measure quantities to the length and width of a thumb.
How Does Rule Of Thumb Works For Businesses And Investors?
In the world of finance, there are a variety of rules of thumb that individuals learn, remember, and apply to finance. You can use these rules of thumb to address procedures and methods for saving. Apart from that, it also helps in investment, home purchases, and retirement planning.
Although the rule of thumb might work for most people when it comes to finance, it might not have a strong application for every situation and every person. This is because an individual has some unique set of circumstances to work on.
Investopedia adds –
“The Rule of 72 is such a quick, useful formula that is popularly used to estimate the number of years required to double the invested money at a given annual rate of return. While calculators and spreadsheets have inbuilt functions to accurately calculate the precise time required to double the invested money, the Rule of 72 comes in handy for mental calculations to quickly gauge an approximate value.”
In the English language, the term “rule of thumb” means an approximate method for performing a job. The method is approximate since it is based on practical experience rather than theory.
Simple “Rule Of Thumb” Examples In Finance
According to Capital.com,
“There are many rules of thumb when it comes to investing. For example, there’s the 4% rule. This is where in retirement, you withdraw 4% of your nest egg’s value each year, plus the value of inflation in every subsequent year. This rule aims to stop retirees running out of funds.”
There are many rules of thumb that are popular for investors. Take a look at some of them:
- If you buy a home, it must cost less than 2.5 years of your annual income or equal to that income amount.
- 10-15% of your take-home income should be for your retirement.
- Your life insurance death benefit must include five times your gross salary.
- Always payoff first the credit cards that are of the highest interest.
- On a long-term average, the stock market gives a return of 10%.
- Your emergency fund equals your household expenses for six months.
- The percentage of bonds in your portfolio should be equal to your age.
- The percentage of stocks in your portfolio should be equal to your age subtracted from 100.
- 40% bonds and 60% stocks makeup a balanced portfolio.
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Importance Of The Rule Of Thumb
Rules of thumb can be a great guide for your financial steps. However, these rules do not apply in every situation. Also, you must not take those rules out of context. A rule of thumb basically includes taking a complex concept and simplifying it for self-interest.
Although a rule of thumb can be a useful instrument for you, you must also be aware of your individual circumstances and risk attitude. You must understand that there are exceptions to all rules. Apart from that, financial markets are also volatile in nature.
In addition to that, a rule of thumb can also be too simple in nature and hence can be problematic for a given situation. As a result, you might underestimate or overestimate your needs and demands.
Furthermore, a rule of thumb might not be useful for a specific circumstance in a given situation. Also, the rule of thumb might change over time. Hence, one must make strong decisions and considerations before making any financial decision.
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soumava goswami
A passionate writer and an avid reader, Soumava is academically inclined and loves writing on topics requiring deep research. Having years of content writing experience, Soumava also loves creating blogs in other domains, including digital marketing, business, technology, travel, and sports.
