The buoyant stock market of the 1990s seemed to change many of the rules of investing. Shorter holding periods for investments and heightened trading became okay, investors accepted greater levels of risk, and heightened expectations became the norm.
About the only rules that did not change were rules of thumb: simple, popular ideas that supposedly give people the “right” steps to take with their money.
Unfortunately, most of these popular notions are flawed. While many are rooted in fact, some are just marketing hype. They are not a means of deciding a financial strategy without actually thinking about it. Instead, they must be looked at carefully, because a rule that works well for one person can leave the next in a heap of financial trouble, due to the way individual differences in savings, spending, risk tolerance, and comfort level translate to the bottom line.
I last took a look at popular notions in personal finance five years ago. It is amazing how little has changed among the rules, although there are one or two new ones that seem to have some merit.
Today, and again next week, this column will Let’s take a look at some of these widely held beliefs about money, savings, and investment and show if any of these rules deserve a thumbs-up.
We’ll start with rules on savings and investment:
– Subtract your age from 100. The answer is the percentage of your investments that should be in stocks or stock mutual funds.
This is a truly horrible concept, leading to an ultraconservative portfolio that is almost certain to leave you with a savings shortfall. For starters, this rule fails to consider how much money an individual needs to save for retirement, how much he has saved already, and the kinds of returns he can expect to get on his money.
What’s more, this formula leaves a middle-aged person with a significant chunk of his money in bonds.
Because middle age is when most people are able to truly squirrel away dollars, the formula means they are putting an enormous portion of their dollars into investments designed to bring safe but low returns.
Most financial advisers scoff at this rule. That said, they laugh far less if you change the 100 in this equation to 140 or 150, so that you have none of your money in bonds until reaching age 40 and have a portfolio that is 60 percent stocks when you reach age 80 (140 minus 80 would leave you with 60 percent of your money invested in stocks).
– Keep three to six months of salary in an emergency fund.
It’s hard to argue with this old saw since it protects you in case of emergency, but the amount of money involved can be prohibitive. Just think of how long it actually takes to save six entire months’ worth of take-home pay; keeping that much money in a safe, low-earning emergency fund surrenders the money’s potential to provide real long-term growth.
To set a personalized guideline, look at your individual situation, including disability insurance coverage, the availability of home-equity credit or access to credit cards, loans against retirement plans, and whether a spouse’s income would suffice in an emergency. Examine the likelihood of a disaster and its potential costs.
If you don’t have significant debt now, credit cards and lines of credit may suffice as emergency protection. If you have debt or work in an industry in which a protracted job loss could be a problem, the full six-month cash cushion could be necessary.
– Set aside 10 percent of gross income for savings.
This isn’t so much a rule as a starting point. Again, it is flawed by ignoring other conditions, such as the return that can be earned on that 10 percent, the time period for building savings and so on.
Whether an individual has an adequate savings level depends more on his needs than on income. That said, however, a new rule on savings and spending probably makes more sense. That rule is:
– One-third, one-third, one-third: Set aside roughly one third of your total earnings to cover taxes, another third for living expenses and the rest for savings.
This is an interesting rule because it actually can work, provided your total earnings are neither very high nor very low. There’s also the problem of how difficult it is for most people to actually set aside more than 30 percent of income into savings, making the input on this rule more unreliable than the outcome.
– When you reach retirement age, live on less than 5 percent of your savings each year and you will not outlive your money.
This is another relatively new rule, and it has some merit. If you need $50,000 to live in retirement, you would need $1 million in savings to accomplish this goal. With conservative returns, you’d have a good shot at living off the interest and not eating into the principal too much. Of course, if you want $100,000 a year in income, you would need to have $2 million saved.
It’s not perfect — market fluctuations and spending vagaries could get you into trouble — but it does emphasize the need to amass a lot of money rather than simply spend greater chunks of what you have.
“Many people assume that whatever their portfolio earns they get to take out and spend,” says Diahann Lassus of Lassus Wherley Associates in Providence, N.J. “They are forgetting about inflation, taxes and other variables, as well as what happens when they have a bad year.”
– To retire comfortably, your investments must generate 70 percent of the income you earned while working.
One of the most widespread rules of thumb, as well as one of the most dangerous, this is another case of a rule that ignores crucial factors. The amount of money needed in retirement is a function of life expectancy, inflation and spending, not previous salary. Someone planning to jet around the globe needs more cash than someone planning to grow his own food in the Appalachians.
And while you may not have a mortgage payment and other key expenses in retirement, ask yourself the following question: Do I want to live the rest of my life with a 30 percent reduction in my available spending money? If you are like most people, the answer is no, and aiming for this 70 percent guideline will leave you short of the standard of living you hope to achieve.
– The stock market will give you a 10 percent annual return.
What many people think is a rule actually is a fuzzy interpretation of a famous stock market study that showed the likelihood that stock investing will deliver annualized average returns of 10 percent.
Among the assumptions that went into the Ibbotson-Sinquefield study were a long-term investment horizon (no jumping in or out of the market), no taxes to pay on dividends and capital gains, and no transaction costs to buy or sell.
In short, 10 percent is not necessarily a real-world number. Worse yet is that this has been treated like a rule so much that people see the 10 percent as a minimum and not an average.
“The problem is that people take 10 percent as the magic number, the least they will get, and they base their savings and retirement spending forecasts on 10 percent as if it is a sure thing,” says Lassus.- Never spend more than 30 percent of your gross monthly income on either your mortgage or rent.
This rule comes from the banking industry, which for years avoided mortgages with payments exceeding 30 percent of gross income. Some banks are more lenient today, but most experts still like to use this rule as the absolute upper limit for a mortgage. Crossing it is likely to make things financially tight for a long time to come.
Of course, spending much less than 30 percent probably is a good idea, too.
– Consumer debt — credit cards, auto loans and other short-term borrowings — should not exceed 20 percent of take-home pay.
Couple this with the 30 percent upper limit on the mortgage and that one-third/one-third/one-third rule falls all to pieces. That said, this is another valid benchmark supplied by the banking industry. Lenders traditionally have found that debt-to-income ratios of more than about 20 percent (excluding the mortgage) make it nearly impossible to catch up and, eventually, get ahead.
The smaller the debt load the better, but try to keep your debt-payment burden — your monthly payments made on consumer debts divided by your monthly disposable income, with the result multiplied by 100 — at 15 or less.
