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Challenging the rules on rules of thumb

balance

By Kyle Tetting

In addition to a long list of undecipherable acronyms, the financial industry is full of rules of thumb. Early on, students learn the “Rule of 72,” a rough guide for how long it takes a number to double at a given annual interest rate. While calculators and spreadsheets can deal in exacts, this rule of thumb is meant to impress upon students the power of compounding. It’s “close enough for jazz,” my high school theater director frequently remarked, although jazz musicians may take exception.

In a variety of circumstances, rules of thumb, or close enough, won’t cut it. In carpentry, you measure twice and cut once. Rocketry, engineering and many other fields demand precise calculations. And, when it comes to how we invest, rules of thumb should serve only as a springboard to a much broader conversation about what’s right for the individual.

One common area where rules of thumb miss the nuance of the individual investor is in ballparking how much retirement income our investments can produce. The rule of thumb is 4%, a more conservative measure than the 5%-5.5% often quoted before the 2008 financial crisis.

The thinking goes that the traditional 60/40 balanced portfolio (60% stocks, 40% bonds) should be able to return about 6% a year over time. Allowing for 2% adjustments to inflation, an investor should then be able to withdraw 4% in perpetuity. Of course, that strategy overlooks the fact that returns don’t come in a straight line and neither does our need for portfolio withdrawals. Additionally, the guideline itself relies on another rule of thumb suggesting that 60/40 is the right allocation for a balanced portfolio.

Recent statements from Jeremy Siegel, Wharton School finance professor and author of “Stocks For the Long Run,” have challenged the simple wisdom of placing 40% of  portfolios in bonds. Siegel argues that with yields at all-time lows for longer-term bonds, it would be unfair to expect the same bond returns over the next 30 years as the last 30 years. Therefore, investors counting on 6% returns must look to stocks to carry more weight.

Siegel is right about at least one part. Bonds have enjoyed a decades-long decline in interest rates that have driven immense returns. The next 30 years are likely to look less robust for bonds. While Siegel’s conclusion—that investors should increase stock exposure—has some merit, it misses the mark for multiple reasons.

For starters, now may not be the time to increase stock exposure. Stocks are expensive by most measures. That doesn’t mean they have to become cheap, but it does suggest a more measured response.

Additionally, there are other ways to add to potential return beyond simply increasing stock exposure. The role of a balanced portfolio is to spread out investments across non-correlated assets, both decreasing risk and, hopefully, increasing potential return. Adding to stocks adds to both risk and potential return, a trade-off that many investors may not want or need.

More obviously, all these rules of thumb miss the most important point: Investing should be tailored to the individual. Every investor has unique wants, needs and tolerances for portfolio volatility. While we can build a model allocation that is right for the average investor, I have yet to meet average.

As one example, a suggestion to increase stock exposure may be of little help to an investor already uneasy about current stock market prices. Increased exposure only exacerbates each market swing.

Likewise, the 4% withdrawal rule of thumb doesn’t help an investor who decides to spring for that once-in-a-lifetime trip for the whole family after getting by on less than 4% year after year in retirement. Rules of thumb can’t account for a deviation in the plan, but life doesn’t happen in a straight line.

Headlines regularly prescribe the right financial moves we all should be making. While there are some near-universal truths to investing, it’s important to remember that there is no one right answer. Instead, we can use rules of thumb as a jumping-off point for a more relevant conversation about what is right for each individual situation.

Kyle Tetting is director of research and an investment advisor at Landaas & Company.

Learn more
For What It’s Worth: Rule of Thumb, by Joel Dresang
Safe investment withdrawals for retirees, a Money Talk Video with Art Rothschild
Investor trade-off: Risk vs. return, a Money Talk Video with Paige Radke
Retirement spending: Safe rates, a Money Talk Video with Art Rothschild
Deciding which retirement accounts to tap, a Money Talk Video with Dave Sandstrom
Retirement spending with heirs in mind, a Money Talk Video with Dave Sandstrom
Retirement requirement: Distributions, a Money Talk Video with Dave Sandstrom
When should I …take my required minimum distribution? by Chris Evers
FAQs about RMDs, from the IRS
Selecting Retirement Payout Methods, from the Financial Industry Regulatory Authority
Risk: How much can you stand? How much do you need? a Money Talk Video with Isabelle Wiemero
(initially posted February 27, 2020)

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