Why investing rules of thumb don't always work

Some might be outdated, others no longer practical.

Ruth Saldanha 16 November, 2018 | 6:00PM
Facebook Twitter LinkedIn

Rules of thumb are intended as guidelines. They are not exact directions, but a rough estimate of what you might need. There are several rules of thumb in investing as well, which are often interpreted in multiple ways.

For example, a rule of thumb for budgeting is the 50-20-30 rule that says that 50% of your income should be used for necessities, 20% should go toward long-term goals, and 30% toward things you want. However, some people swap the last two while others reject them altogether. In fact, advocates of the F.I.R.E. (financial independence, retire early) movement sometime recommend saving over 70% of your income toward long-term goals!

Similarly, another rule of thumb states that your entire student debt should not be more than your first year’s salary -- but with rising tuition costs, this rule may not be feasible for many.

Today, we examine five such rules of thumb, and try and see whom they might work for, and who might need to tweak them.

Rule 1: 100 minus age = equity

This is a rule of thumb that’s often used for asset allocation. What it means is that if you are 30 years old, you invest 70% of your portfolio in equity and the rest in fixed income investments.

The main thing to remember with this rule, though, is that when it first came about, people didn’t usually live as long as they now do.

"People are living longer than ever before, and we as planners aim for a lifespan of 95 years or even more," says Rona Birenbaum, certified financial planner and founder of Caring for Clients.

To account for this increase in lifespan, some experts suggest 120 minus age = equity as a new rule. However, even that might not necessarily be accurate, Birenbaum points out.

"This rule does not consider other sources of cash flow, for example income from the Canada Pension Plan or Old Age Security, or whether you have a defined-benefits pension plan. If you have these alternative income streams, then you might be able to take a higher level of risk. Alternately, even a relatively young person might not be comfortable with taking very high risks. So equity allocation would need to depend on what the investor is comfortable with," she notes.

She recommends that younger investors have a significant bias toward equity, while mid-career professionals allocate 70% to equity. For those closer to retirement, with a moderate risk tolerance, a 50-50 balance might work, Birenbaum says.

Morningstar’s director of personal finance Christine Benz is a fan of the bucket strategy for asset allocation in retirement.

"The bucket concept is anchored on the basic premise that assets needed to fund near-term living expenses ought to remain in cash, dinky yields and all. Assets that won't be needed for several years or more can be parked in a diversified pool of long-term holdings, with the cash buffer providing the peace of mind to ride out periodic downturns in the long-term portfolio," Benz notes.

Rule 2: 4% annual withdrawal in retirement

In 1994, financial advisor William Bengen concluded that a person could withdraw up to 4% annually from their portfolio without fear of outliving their money. He arrived at the figure based on historical stock returns and retirement scenarios.

"At the time, the rule seemed prudent based on historic returns. However, the first 10 years of market performance in withdrawal make a huge impact on the rest of the retirement funds. If the first 10 years of returns are positive, then that will be overall good for your portfolio, but if the first 10 years are flat or negative, that would be bad," Birenbaum notes.

She adds that over the past 10 years, the stock markets have enjoyed a positive run, which makes it possible that the next 10 years are likely to not perform as well. It is equally likely that bond returns will be lower, she says, and she suggests perhaps a 3% drawdown might be more prudent.

Matthew Williams, senior vice president at Franklin Templeton Investments Canada suggests that a fixed rule might not work for every investor, as some investors might need more funds, while others might need less. He suggests that rather than the minimum withdrawal limits currently in place on registered retirement income funds, it would be more prudent to consider a range of minimum as well as maximum limits on RRIF withdrawals for a year.

Rule 3: Have 3-6 months of expenses in an emergency fund

"Emergency funds need better messaging because they're an absolutely crucial aspect of any financial plan, regardless of life stage or situation," says Benz.

But should you have as much as six months of expenses saved up?

Like all rules of thumb, this might be a good starting point, but how much you actually need depends entirely on your personal situation. For investors in a steady and stable job, with little to no high-cost debt, and with adequate insurance, perhaps six months of expenses sitting in cash in an emergency fund might be too much. On the other hand, for those employed in the gig economy, with volatile income flows and lack of employer benefits, a three-month buffer might be too little.

"It all depends on what your situation is. In my experience, people overestimate the probability of an emergency. If you have access to a low-cost line of credit, that could perhaps be an alternative to an emergency fund. On the other hand, repayment of high-interest debt should be a priority," Birenbaum said, noting that especially for those in high-debt situations, repayment of debt and staying clear of additional debt are important aspects to keep in mind.

Rule 4: You can retire when you have 20x your annual income

"It’s a mistake to try to set your target savings rate in a vacuum. You need to think about a couple of things. One is that, if your retirement is many years in the future, what seems like a lot of money today may not actually purchase that much when you're ready to retire. And then if you're closer to retirement, it's really important to keep in mind how much you plan to spend," Benz said.

Birenbaum also points out that what your retirement looks like to you will dictate how much money you need. "If you have full CPP/OAS benefits, a fully paid-off home and a pension, 20 times might be too much. If you want an expensive retirement, it might not be enough," she said.

Rule 5: The 20/4/10 rule for car ownership

This rule says that when you buy a car, you should put 20% down, spend no more than four years financing it, and it should cost no more than 10% of your income. While it is a good idea to not overspend on a car, Birenbaum points out that most people see cars as being aspirational, and not merely as a mode of transport.

"It is important to prioritize goals, and a car is not necessarily a goal. Major goals include education, retirement, home ownership and paying down high-interest debt -- allocate for those, factor in your lifestyle, and what is left is transport. Frankly, a car is just a mode of transport. The alternative to a car is public transit," she said.

Facebook Twitter LinkedIn

About Author

Ruth Saldanha

Ruth Saldanha  is Editorial Manager at Morningstar.ca. Follow her on Twitter @KarishmaRuth.


© Copyright 2024 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy       Disclosures        Accessibility