OK, they can be quite useful, but it was a catchy title and it rhymed. A rule of thumb is meant to provide a guideline on a specific topic that applies to a broad set of people BUT is not intended to be strictly accurate or reliable for every situation. Below are two examples of rules that came up in a recent conversation that, while helpful in a broad sense, would not apply in all cases.
- Portfolio Risk – Take 100 and subtract your age; that is the percentage of your portfolio that should be invested in stocks. More recently, I have seen the rule updated to 120 minus your age since life expectancies have increased since the original “rule” came about. Either way, the rule has good intentions – to decrease the volatility of your portfolio as you get older and, presumably, need to withdraw more from a smaller portfolio that’s been used to support your lifestyle for a number of years. On top of that, your shortening life expectancy allows less time to recover from a market downturn. But not everyone who is 80 years old fits that description. For instance, I recently had a conversation with someone in his eighties who has a substantial portfolio but also has SSA income and a pension. He’s a very good saver (good habits are hard to break) that he still spends less than he brings in on a monthly basis. So, in his case, should he own less than 20% stock in his portfolio that will, almost certainly, be passed to his children who have a much longer runway in retirement? The argument could be made that his portfolio should be more in line with the children’s timeframe than his.
- Another example is someone that has been a good saver all their life, they’ve invested wisely and live well below their means. Now that they are in retirement and no longer seeing that steady paycheck hit their account every other week, the fluctuations of the stock market keep them up at night. Let’s assume they’re 60 years old which, by the updated rule, would indicate their portfolio should own 60% in stocks. If they can reach their goals with only 40% in the stock market and sleep better at night, then why isn’t that a better option for THEM?
Spending Level – The 4% Rule
The 4% rule, in short, was developed by looking at historical 30 year rolling periods for a portfolio of 60% stocks/40% bonds and observing the maximum percentage that could be withdrawn from a portfolio – based on the current value and adjusted for inflation – over a 30 year period without ever running out of money. That is: never in those 30 years, was their investment depleted. Again, a good guideline with great intentions. If you have no way of determining what level of withdrawals is right for you, then this gives you an idea… don’t withdraw more than 4% and you should be ok. Let’s go back to the same conversation I referenced in the example above. If you are in your eighties, is this a helpful rule in determining how much you can spend from your portfolio? Should we be using a rule of thumb that is meant for a 30-year time frame to determine how much he can safely withdraw? Likely, you’ll end up utilizing much less of your savings than you could have. I used to “utilize” rather than “spending” because this may mean gifting more to children and grandchildren now, when you can see the benefit, rather than after you’ve passed.
Conversely, the FIRE (Financial Independence Retire Early) movement often references the 4% rule to support spending for people that retire at age 40 and plan to live off of their portfolio throughout their extended retirement (expected to be well in excess of 30 years). The rule wasn’t tested, and therefore doesn’t apply to a 50-year period. In the first case, the person is more likely to spend less than he could by applying the 4% rule while, in the second case, there’s a much greater risk that the portfolio will be depleted by spending the full 4%.
As these examples illustrated, rules of thumb are useful in providing a framework but not every situation fits nicely into the rule. Make sure you are making decisions based on YOUR situation that align with YOUR goals as outlined in your financial plan.