Media Briefings

New study proposes ‘optimal rules of thumb’ for household saving and investment decisions

  • Published Date: September 2013

PERSONAL FINANCIAL ADVICE: New study proposes ‘optimal rules of thumb’ for household saving and investment decisions


Complicated academic models of financial decision-making in an ideal world can be turned into practical guidelines for households and financial advisers, according to research by Professor David Love. In a study published in the September 2013 issue of the Economic Journal, he shows how these guidelines – what he calls ‘optimal rules of thumb’ – can generate better outcomes than the advice typically offered on popular personal finance websites.

He begins by noting that the personal finance industry is rife with rules of thumb for saving and investment decisions. Common rules include saving 10% of pre-tax income, withdrawing 4% of saving in retirement and allocating 100 minus your age percent of your financial wealth in the stock market.

While these rules have the appeal of simplicity, they tend to be inconsistent with a growing body of research on saving and investment, which suggests that optimal rules about household financial decisions should generally depend on a complicated interaction of factors including wealth, income, housing, age, health and even marital status.

A natural question is whether it is possible to bridge the gap between the simplistic rules of thumb offered on personal finance websites and the more sophisticated research on optimal behaviour in the literature of economic research. According to Professor Love, the answer is yes.

His study seeks to find a middle ground between accessible rules of thumb and the optimal advice stemming from large numerical models of household saving and asset allocation. The starting point for the project is the recognition that any rule of thumb is just a particular version of a more general underlying function.

Instead of investigating whether particular rules of thumb for financial decisions seem reasonable (which has been the approach in previous studies), Love searches for what he calls ‘optimal rules of thumb’. An optimal rule of thumb is the highest performing rule of a general class, where performance is measured relative to the efficiency of the more complicated rules derived from the standard lifecycle framework.

The advantage of looking at optimal rules of thumb is twofold. First, since the parameters of a simple rule of thumb have been chosen to deliver the highest possible performance relative to the more complex solution, the approach can help answer the question whether any rule of thumb can offer a reasonable alternative to the more sophisticated (and less user-friendly) advice derived from the lifecycle model.

If an optimal rule of thumb performs poorly, it suggests that it may be worth the effort for households or financial advisers either to consider a different class of rules of thumb altogether (that is, a different type of general function) or to tackle the complex optimisation problem.

But if the efficiency loss associated with an optimal rule of thumb is relatively small, it means that it is possible to combine the appeal of simple advice, for which there appears to be demand, with the efficiency properties of models that would otherwise be difficult for typical households or financial advisers to solve.

Second, the optimal rules identified by the framework might be of interest in and of themselves. The research solves for optimal rules of thumb for both saving and investment decisions.

In some cases, the optimal rules of thumb generate very small efficiency losses relative to the solution of the more complex model. For example, a general version of the common age-based rule for allocating wealth in the stock market introduces efficiency losses worth around 0.4% of total annual consumption from the perspective of a household just starting out their working life.

A slightly more complicated rule of thumb based on household wealth performs even better, with losses closer to 0.2% of annual consumption. In comparison with the optimal portfolio rules, the optimal rules for how much to save each year are less successful in matching the efficiency of those associated with the first-best lifecycle model. Here, the losses tend to range between 2-5% of annual consumption.

These losses assume that households stick to a given rule for the remainder of their life. If households can revisit the optimal rule of thumb a few times throughout their lives, the welfare losses fall to as low as 0.04% in the case of portfolio choice and close to 1% in the case of saving.

These losses are substantially lower than those associated with the kinds of advice currently offered on popular personal finance websites, suggesting that optimal rules of thumb may indeed be of more than academic interest to households and financial advisers.

ENDS


Notes for editors: ‘Optimal Rules of Thumb for Consumption and Portfolio Choice’ by David Love is published in the September 2013 issue of the Economic Journal.

David Love is at Williams College in Williamstown, Massachusetts.

For further information: contact Romesh Vaitilingam on +44-7768-661095 (email: romesh@vaitilingam.com; Twitter: @econromesh); or David Love via email: David.A.Love@williams.edu