A Report Card for Financial Rules of Thumb
I’m not a big fan of “rules of thumb.” These are bite-sized nuggets of wisdom masquerading as advice, designed to apply to a mass audience. At best, they cant point someone in the right direction, but at worst, rules of thumb can erroneously send people on the wrong path or can mistakenly instill a false sense of security. This is a good example of why the best financial advice is specifically tailored to an individual or a family.
Rules of thumb satisfy the human desire for knowledge on a stick, like fast food for the brain. They are easily repeatable and retweetable, and they invite a minimum of critical thinking. But it would be unfair to suggest ignoring all rules of thumb. Some are better — more accurate for a larger number of people — than others. But it’s important to determine which ones apply to your situation and which one’s are not relevant.
Here are some of the more popular rules of thumb targeting personal finances, often repeated by gurus and writers targeting a wide audience.
You should save 10 percent of your income. Grade: B-.
This rule of thumb is not specific. It is not clear whether 10 percent should be counted before or after taxes. Saving this percentage of your gross income, a larger sum than the same percentage of your “take-home” income, would be preferred. This rules of thumb also does not specify whether your 401(k) or other investments are included or if this only refers to savings not invested or spent.
I can’t say that saving 10 percent is a bad idea. This is a good starting point; in fact, putting this portion of your income away without touching it will put you far ahead of the “average” American. Many people, however, will need to save more, some significantly more, than 10 percent in order to meet their goals. This rule of thumb, ingrained in the minds of many people who have read books suggesting this amount, can convince someone than 10 percent is enough.
Your emergency fund should be large enough to replace 3 to 6 months of your income. Grade: D.
Again, this is a good starting point, but your income is not related to the size. Your emergency fund should be allow you to afford your non-discretionary expenses while you work to replace your income. Determining the right size for your emergency fund requires measuring your monthly expenses, judging the stability of your income, determining what you would be willing to do to replace that income, considering how much it might cost to relocate in an emergency, and seeking expenses to cut.
The economy and the job market — how long it might take you to find a new job — should be a consideration as well. A better rule of thumb might state that the size of your emergency fund should be enough to cover necessary expenses for the number of months equal to the unemployment rate. For example, if the unemployment rate in your state is 10 percent, your emergency fund should be large enough to cover 10 months’ worth of expenses.
You can withdraw 4 percent of your nest egg in retirement to provide yourself an income while keeping enough invested to last indefinitely. Grade: C.
The 4 percent “safe withdrawal rate” relies on a number of dangerous assumptions. First, the funds from which you take the 4 percent must be invested completely in a diversified selection of stocks, like the S&P 500. As we’ve seen recently, beginning retirement while completely invested in stocks in a year where the stock market is down can be disastrous to financial health. Secondly, in assumes the stock market will perform 5 percentage points higher than inflation. That’s a reasonably good estimate when you look at the stock market on average, but there is rarely an average year. The stock market performs significantly better in some years and significantly worse in others.
The rule of thumb is not detailed enough to explain, but 4 percent is the withdrawal rate for the first year only. The withdrawal in every subsequent year should increase by the rate of inflation. For example, if you withdraw $40,000 from your $1,000,000 in the first year, and in the second year your nest egg increases to $1,001,000 after a year where inflation was 3%, your withdrawal in the second year should be $41,200 (3% more than $40,000) rather than $40,040 (4% of your new balance).
To find the percentage of your portfolio that should be invested in stocks, subtract your age from 100. Grade: F.
According to this rule, once you are no longer a minor the most you’ll be invested in stocks or stock mutual funds is about 80 percent. Someone retiring at age 65 would have a portfolio only 35 percent invested in the stock market. This directly contradicts what would be necessary to make the 4 percent safe withdrawal rule of thumb a reality. And for most people, the calculation using 100 just simply won’t cut it in order to grow wealth over the long term.
There’s more to consider. Suze Orman has a massive net worth compared to most people, and can therefore afford to play it safe by investing almost all of it in bonds. Stocks are riskier, and she and other people with significant net worth do not have to take on as much risk as what is found in the stock market to provide more than enough income for the rest of their life. Not only that, but significant wealth in a less risky investment helps ensure there will be an estate to leave to family or charity at the end of life.
The rest of us must take on the risk of the stock market in order to provide the best chance of building wealth in the long term. And the amount of risk needed for us is a higher percentage than the result of subtracting your age from 100. Perhaps 130 or 140 would be a better figure to use.
To retire comfortably, you will need to have an income of 80 percent of your maximum pre-retirement income. Grade: C.
Although it’s common to believe your needs, and therefore expenses, will be less in retirement, reality shows that this is not always the case. It is safer to assume that your expenses will be 10 percent higher in retirement. Keep in mind that health care costs will most likely rise dramatically as you age. And with people living longer than ever, those expenses will last for many years.
Once size does not fit all. Rules of thumb are good starting points, but don’t fall into the trap of believing you are safe if you follow these rules. Do you know of any other rules of thumb deserving a thrashing?
Photo: John Leach