OPTIMAL RULES OF THUMB FOR CONSUMPTION AND PORTFOLIO CHOICE

Conventional rules of thumb represent simple, but inefficient, alternatives to dynamic programming solutions. This article seeks an intermediate ground by developing a framework for selecting optimal rules of thumb, where rules of thumb are defined as simple functions of state variables. In the case of portfolio choice, optimal linear age rules lead to only modest welfare losses relative to the dynamic programming solution, while a linear rule based on the ratio of financial wealth to total lifetime resources performs even better. Consumption rules generate larger welfare losses but an effective rule is to consume 70-80% of annuitised lifetime wealth.