How Rules-of-Thumb Steal Your Money
We all use rules-of-thumb to navigate life. If we didn’t, we’d never get anything done. Unfortunately, your rules-of-thumb might be stealing you blind.
A rule-of-thumb is a general rule or principle developed through experience. The key here is that rules-of-thumb are not based on science. As a result, they might work some of the time, but not all of the time. And in a worst-case scenario, they might be flat wrong.
(Fancy Term Alert!) Behavioral economists and psychologists call rules-of-thumb “heuristics.” A heuristic is simply a quick way to make a judgment or solve a problem.
I don’t care if you call it a heuristic or a rule-of-thumb. It’s the same thing. Humans need simple rules to choose and solve problems. Especially when faced with complex problems or incomplete information.
The problem isn’t that you use heuristics and rules-of-thumb – because you do. The issue is that the heuristics and rules-of-thumb you use are often biased and wrong. This isn’t much of an issue for small decisions. However, it can be a game changer for important decisions.
Here’s an easy one. “Drink eight, 8-oz glasses of water a day.” For most people, drinking that much water does no harm – except for the excessive time spent in the bathroom. However, a little rational analysis might make you reconsider.
- Why 64 oz?
- Did you factor in your weight and lifestyle?
- How about your activity level?
- Temperature and humidity might be a factor.
- Did you know that drinking too much water can kill you? It’s called hyponatremia. If you drink too much water you might dilute or flush out the sodium and electrolytes in your body. This is not good, especially if you are running a marathon.
Let’s list a few money heuristics and rules-of-thumb.
- People retire at 65.
- You only need 80% of your income in retirement.
- Young people should put their money in stocks. Old people should put their money in bonds.
- Your college savings account should be in conservative bonds and cash when your child graduates from high school.
- Gold never loses its value.
- Real estate never loses its value.
- Buy land because they aren’t making any more of it.
- Change the oil in your car every 3,000 miles.
- Debt is bad.
- Debt is good.
- You only need life insurance when you are young.
- Buy term and invest the rest.
- Keep one car’s length gap per 10 mph of speed.
- My (fill in the blank) guru said . . .
- Buy and hold.
There are more – lots more. The key takeaway is not the wisdom of the statement but whether it is appropriate or suitable to you and your situation. And how do you know?
Humans like money heuristics and rules-of-thumb because they make us feel good and give us a sense of control. This is not a problem for minor transactions. Major purchases and investments are another story.
When you are faced with a complex important money decision:
- Get out of your feeling brain and into your thinking brain.
- Find an objective, impartial third party who can help you work through the process.
- Define your money values – what is truly important to you and what will it cost.
- Know your money temperament – how you think and feel about money.
- Know how you process information – how you like to communicate and learn.
- Rationally develop a money strategy.
- Rationally execute your money strategy.
- Get feedback and adjust when appropriate for you.
What’s your favorite money rule-of-thumb? Do you still believe it works for you? Why?