Seven Financial 'Rules-of-Thumb' That Make Little Sense
With the stock market gyrating like a belly-dancer on speed and the economy seemingly running on empty, many consumers are wondering if the tried-and-true tenets of investing, spending and saving still work.
The problem is that the rules-of-thumb that many people want to try aren't necessarily true. In fact, while many common financial concepts start with good intentions, they are frequently misquoted, misguided or simply misleading, regardless of the market conditions.
That shouldn't be entirely surprising, given the generic nature of most broad guidelines. The late Lynn Hopewell, a sage financial adviser and former editor of The Journal of Financial Planning, once noted that "Rules-of-thumb are for people who want to decide things without thinking about them."
If you think about the rules-of-thumb, however, it becomes clear that many of them don't make a whole lot of sense. For proof, consider these 10 "rules" that people commonly apply to their finances:
1. Subtract your age from 100
The answer is the percentage of your investments that should be in stocks or stock mutual funds.
This rule became popular in the 1970s and '80s with the emergence of retirement plans, as individuals tried to come up with a handle onwithout necessarily trying to conquer the subject matter.
In practice, this rule is severely flawed, failing to look at the whole picture. Everything from life expectancy to age at retirement, from amount invested to expected returns and much more impacts a portfolio's ability to last a lifetime. Most advisers seem to think this rule is ultraconservative and would be more comfortable if the number were readjusted to 130 or 140.
"This rule has completely outlived its usefulness, because people are retiring younger and living longer," says Peg Eddy ofin . "People are retiring with 20 years or more to live, and a portfolio that is too conservative just isn't going to work for them. They need more growth, or they will be too vulnerable to inflation over that longer stretch of time."
2. Keep three to six months of salary in an
Advisers have struggled with this one for years because an investor can spend years trying to save six months' salary, and then keeping that money liquid for emergencies surrenders big growth potential.
A better rule might be to focus this rule on living expenses, rather than gross income. That allows the emergency fund to cover its intended purpose, namely paying the bills rather than replacing lost paychecks. The necessity of these funds can depend on a variety of factors, including disability insurance protection, the availability of credit and the potential costs a family would face from a job loss, health problems or the breakdown of cars and big-ticket household appliances.
Chances are, the average consumer will never face an emergency that requires them to come up with six months' of salary within 24 hours, which is why some advisers suggest that emergency funds can do double duty, being an investor's most-conservative bond investments while being accessible if the worst happens.
3. Set aside 10% of gross income for savings
This isn't really a rule, according to experts, as much as it's a starting point. It's hard to say "this is the right percentage to save" because that ignores several factors, like the return that the money can earn, how long someone has to build a nest egg and the lifestyle someone wants to maintain.
If this rule gets people to save -- even if they can't afford to get all the way to 10% of income -- then it's better than nothing. But if you follow this rule expecting it to deliver a secure retirement, you may be sorely disappointed.
4. To retire comfortably, your investments must generate 70% to 80% of the income you received while working
Not a bad idea, but too many critical factors are being ignored (again). Retirement needs are a function of life expectancy, good or bad health, inflation and spending, not previous salary. Living a jet-set lifestyle requires a lot more money than staying home and watching television; failing to generate enough income can force retirees to give up a lot of the activities that should make their retirement years more enjoyable.
"Most folks who hit 65 these days -- if they wait that long to retire -- are finding that they have more energy and more desire to do more things, and they need to plan on a higher level of spending in the early years of retirement," says Rick Brooks, vice president of investment management for Blankinship & Foster, a., advisory firm.
"Sixty-five is the new 55, where folks still have energy, they have resources and they are no longer shackled by the 9-to-5 job thing. While those conditions will change over time, someone who doesn't replace all of their income may draw down too much early, and then may be in a position where they outlive their assets."
5. The stock market will give you a 10% annual return
This is a fuzzy interpretation of the famous Ibbotson-Sinquefield stock market study, research that showed the stocks deliver an annualized average return of 10%. The problem is that Roger Ibbotson, the guy behind the study, now says that he expects the next 25 years to be different from the last 75, with returns closer to 8%.
Moreover, the 10% number includes several assumptions, such as a long time horizon -- no active trading -- no taxes and no transaction costs. That's hardly real world.
Also, many people forget that the historical returns are an average, not an annual total. When people live by this rule, and make it their expectation, they tend to be easily disappointed, which makes it tough to stick to any investment strategy.
6. Life insurance benefits should equal five times your current income
Critics say this is a long-time insurance industry marketing ploy, while supporters call it an honest benchmark. Either way, it's usually off-target; a key problem, again, is the focus on income rather than expenses.
Experts say the five-times-income rule applies to the sole breadwinner in a family with two kids. That makes it inadequate for larger families, or a waste for people yet to start a family. Like most financial rules of thumb, this rule's suitability is a function of your personal situation.
Rather than relying on income, a more accurate formula for many consumers will be to insure what they can't afford to pay for without coverage. That means taking their mortgage balance, the kids' college education, and four or five years' worth of expenses to allow your loved ones to get back on their feet emotionally.
7. Refinance your home when interest rates drop by 2 percentage points
This rule came from the era where the points -- the fee paid to lenders for making the loan -- andassociated with a took years to pay off. Today, there are many available mortgages with little or . As a result, consumers can get long-term savings by shaving a half percentage point or more from the mortgage or by keeping the rate, but shortening the loan's duration.
The consensus of the experts: Work the numbers. You could be wasting money waiting for rates to fall far before you make a deal.