Optimal Rules of Thumb for Consumption and Portfolio Choice

Conventional rules of thumb represent simple, but potentially inefficient, alternatives to dynamic programming solutions. This paper seeks an intermediate ground by developing a framework for selecting optimal rules of thumb. Defining rules of thumb as simple functions of state variables, I solve for the optimal parameters of specific rules of thumb for portfolio choice and consumption. In the case of portfolio choice, I find that optimal linear age rules lead to modest welfare losses relative to the dynamic programming solution and that a linear rule based on the ratio of financial wealth to total lifetime resources performs even better. Consumption rules generate larger welfare losses—from 1–8% of annual consumption—but an effective rule is to consume 70–80% of annuitized lifetime wealth. JEL classification: G11; G22; D91; E21