Rules of Thumb in Household Savings Decisions: Estimation Using Threshold Regression

The rules of thumb offered by financial advisors regarding how much to hold in liquid reserves vary widely and usually imply far greater sums than low-income households save. This paper seeks empirically-grounded insights into the minimum liquidity buffer needed by the average low-income household. First, we document diminishing benefits to liquid savings in terms of the likelihood of experiencing financial hardship. Then, we formalize this relationship with a theory of poverty traps. Finally, to observed data, we fit a regression kink model with an unknown threshold (kink) point that must be estimated. Our key finding is that the threshold point is $2,467 with a 95% confidence interval of $1,814–$3,011 (in 2019 dollars) or roughly 1 month of income for the average low-income household – which is far less than the savings amounts implied by common rules of thumb (typically 3–6 months of income). Theoretical evidence suggests that financial advice based on an empirically-estimated threshold point is welfare enhancing for households with naive perceptions of their probability of experiencing financial problems.