Many of us use rules of thumb to help us create good habits. Sometimes, however, we may find that our rules of thumb are really old wives’ tales such as, “An apple a day keeps the doctor away.” While eating apples is a good habit, it doesn’t necessarily keep us from ever needing a doctor’s visit. The same could be said about some financial rules of thumb.
We’re here to clear up the misconceptions of these “Rules of Thumb Dumb”. Most times, these so-called rules don’t actually have the outcome investors expect.
The Multiply by 25 Rule
As individual investors, we may ask ourselves how much we will need to retire. That’s what the Multiply by 25 Rule is supposed to tell us. The rule assumes you will live for 25 years in retirement. The rule also assumes your yearly expenses in retirement should remain the same every year. For example, the rule says that if you need $40,000 to live on each year, multiply that by 25. So, $40,000 x 25 = $1,000,000.
There are problems with this “Rule of Dumb.” First, people are living longer than they used to so they actually updated the rule with a new formula using 34 years as an average of retirement span: $40,000 x 34 = $1,360,000. Second, you have to consider inflation and how far you are from retirement. For a person who is 25 years from retirement, by the time you figure inflation into the equation, your yearly number will be a lot higher than $40k. How do you know 25 years before you retire how much you’ll actually need in retirement? There are so many things that could change before then.
The 4% Rule
The 4% rule is just the inverse of the Multiply by 25 Rule. This rule is supposed to tell you how much money you can withdraw annually from your investments to live on. The rule basically says you multiply your retirement assets by 4% to determine how much you can withdraw each year without running out of money before you run out of time. For example, $1,000,000 saved x 4% = $40,000 annually. Again, people are living longer than they did when this rule was invented, and things cost more because of inflation. Moreover, a major flaw with this rule of thumb is when the market takes a downturn. Let’s say your $1,000,000 today becomes $800,000 due to a market decline. If you take the same 4% to apply to your income formula, you now have to take a decrease in income. Your income is now $32,000 per year. Should you have to live on less because of a market decline? There are strategies that we employ at GenWealth Financial Advisors that can allow your income to increase regardless of a market decline.
The Rule of 100
This rule of thumb speaks to the amount of stocks a person should have in their portfolio based on their age, and is the dumbest rule of all. For instance, someone who is 50 would keep 50% of their portfolio in stocks. When they turn 60, they should have 60% of their assets in fixed income and 40% in equities. While that’s an easy enough equation, what about Social Security? What role does that play here? And what about individual risk tolerance? There are too many factors to make a blanket recommendation on allocation based on age alone.
While “Rules of Thumb” can help develop good savings habits, they’re no match for an education-driven, strategy-based, and team-delivered approach to your retirement. So, the next time you’re standing around the water cooler and someone mentions one of these rules, you’ll be able to help them, because knowing is half the battle.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
