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Sizing Up Rules of Thumb

By Sam Beres

Everyone uses rules of thumb as short, easy ways to remember or explain principles. Too often, though, we adhere to these adages without any thought to their source or track record. When it comes to matters as important as our financial future, catchy maxims deserve some scrutiny. Here’s a handful of examples.

1. Save 10% of your income for retirement.

According to the Employee Benefit Research Institute, 50% of American workers are not confident they will have enough money to live comfortably throughout their retirement. The root of this lack of confidence: Lack of savings.

A general rule of savings advises workers to save at least 10% of their gross pay for retirement. But the percentage is not as important as the frequency and regularity of setting money aside. Saving early and consistently leads to more confidence and greater financial security later in life.

2. The Rule of 100 for stock allocation.

The Rule of 100 suggests that 100 minus your age should be the percentage of your portfolio allocated to stocks. For instance, if you’re 54, 46% of your allocation would be in stocks; or 38% if you’re 62. While this correctly preaches a more conservative approach as an investor ages, it does not automatically maximize returns in relation to risk.

The Efficient Frontier demonstrates the importance of the mixture of stocks and bonds in helping an investor achieve a considerable return without assuming unnecessary risk.

“I’m all for risk, but only if I’m getting paid for it,” says Marc Amateis, vice president at Landaas & Company. According to Amateis, most portfolios should not have more than 60% of assets in stocks because any additional prospects for growth aren’t worth sacrificing the capital protection sought by investors.

A balanced portfolio is diversified across the various asset classes – stocks, bonds, commodities and real estate. This allows investors to better weather the economic down cycles yet they still may reap the benefits of a bull market.

Each investor’s objectives and acceptance of market uncertainty can vary, so it’s important to monitor both your portfolio and your tolerance for risk. As Landaas & Company vice president Art Rothschild says, “It’s never too late to reallocate.”

3. Investments return 8% per year.

When planning for retirement, set reasonable expectations for the growth of your portfolio. Over the past 50 years, the average total return of stocks is approximately 11% while the historical return on bonds is about 5%. This means that an investor holding a balanced 50-50 portfolio can expect an 8% nominal return over the long-term.

However, you need a long-term mindset. Very few years in the market are actually average. In fact, over the past 50 years, stocks have provided annual returns between 10% and 12% only three times. Objective investing, which includes consistently maintaining a balanced portfolio, can help investors maintain this long-term outlook and avoid being caught up in the latest market fad or making irrational decisions.  

4. Keep your total debt-to-income ratio at 0.36 or less.

Every American should know the problems that debt can cause.

Think twice before using debt to buy depreciating assets – cars, furniture, electronics. A car may be necessary to commute to work, but debt payments can hinder your ability to save properly, thus jeopardizing your retirement planning and future financial security.

A better case can be made for holding some debt connected to appreciating assets – a college degree or a house – as they can contribute to prosperity over time. Be reasonable in the amount of debt used to finance these assets, though.

Again, the number isn’t as important as the principle: Limit debt. If you decide to borrow, understand the consequences and avoid letting it hamper your financial goals.

5. Withdraw 4-5% a year from your retirement fund.

It so happens that 5% is a reasonable annual withdrawal rate. It takes into account the historical expected return of a balanced portfolio – 8% (See above.) – and the historical rate of inflation – 3%. Withdrawing 5% from a portfolio means that – if historical averages remain true – you would not have to touch your nest egg.  

Sometimes, rules of thumb can offer rough estimates, but they do not tailor themselves to each individual’s financial situation. Be cautious about acting financially on one-size-fits-all guidelines. Consider rules of thumb with a grain of salt, and never be afraid to seek professional help.

Sam Beres is a summer intern at Landaas & Company. He is a finance major at the University of Notre Dame.

initially posted Aug. 12, 2011

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