Be Wary of Rules of Thumb

Rules of thumb — whether they address when to plant grass or how long to cook a turkey — attempt to simplify our decision making. However, when it comes to your financial life, following rules of thumb may be unwise.

For example, consider the “Rule of 100” which dictates that investors simply subtract their age from 100 to arrive at the ideal percentage of their portfolio to invest in equites. Follow that logic and a 25 year-old has 75% in stocks and a 75 year-old has 25%. Sure, the younger you are the more risk you can tolerate. But the flipside of that equation is not so clear-cut. In fact, today’s historically low yields mean retirees are struggling to generate the income they need from bonds. And as longevity continues to increase, it can be argued that retirees need more potential for growth than they once did. What’s more when you weight a portfolio heavily toward bonds as you close in on retirement, you expose yourself to interest rate risk. So, certainly in today’s unique environment, the Rule of 100 is ripe for re-assessment. The asset allocation of a retiree’s portfolio should be determined by a prudently prepared financial plan while carefully assessing one’s risk tolerance. Keep in mind that Warren Buffett has said that his instructions to his wife are to have 90% equities and 10% bonds.

The simple fact is that stocks are almost certain to produce higher returns than bonds over the long term. I preface the following statistics with the standard warning that past performance does not guarantee future results. However, according to Morningstar, over the last 90 years stocks have outperformed long-term Treasury bonds, on average, by 4.4 percentage points a year. Stocks also out-performed intermediate- and short-term Treasuries by 4.8 and 6.6 percentage points, respectively. Additionally, over 30-year rolling periods, stocks have always outperformed Treasury bills and intermediates, and have only rarely underperformed long-term Treasuries. Shorten the window to five -year periods, and stocks beat bonds 71 to 76 percent of the time.

The catch, of course, is there is plenty of intra-year volatility with stocks. Accordingly, the key for anyone invested primarily in stocks is not to bailout at a low point, thereby locking in losses. It’s the job of a trusted advisor to ensure the portfolio is liquid enough to ensure that doesn’t have to happen. An advisor can also help cultivate the essential long-term perspective that’s necessary to override fear and prevent emotions from driving a client’s investment decisions.

There are other rules of thumb that are suspect and even dangerous today. Take the “10, 5, 3 Rule” that sets an expected return of 10% from stocks, 5% from bonds and 3% from highly liquid cash-like accounts. Today’s environment of low and slow growth and historically low interest rates makes those numbers wishful thinking.

Of course, the “4% Withdrawal Rule” has also come under fire recently. Here, the thinking has been to withdraw 4% from your portfolio in the first year of retirement. The next year you take out the same amount you took out the first year, adjusted for inflation. In order to ensure you don’t run out of money in retirement, however, it may be prudent to base your withdrawals on the market’s performance.

Of course, there are some investment rules of thumb that still hold true. My favorite is “Pay yourself first,” ideally 10% of your pre-tax income. Of course, that takes discipline. And that’s where your 401(k) comes in. I encourage all investors to max out their 401(k)–and to contribute at least as much as is necessary to qualify for any company matching funds. And, of course you should increase your contribution every year. If you practice disciplined saving from the very beginning of your career, you can take the greatest constant in investing–the power of compound interest!

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