4 financial rules of thumb in need of upgrades «
I recently gave a talk to a regional Lions Club, and the questions quickly turned into a referendum on some of the oldest financial rules in the book.
Peter wanted to know if subtracting his age from 100 and using the result for his stock allocation really built an appropriate portfolio. Steven wanted to know whether keeping a small-but-steady allocation to gold was really necessary. Ron asked about being able to get by in retirement on withdrawals from savings of 4%annually.
Click to Play Ignore the market’s 2013 results2013 was a great year for stocks, and that has investors doing the exact wrong thing. Chuck Jaffe joins us to talk about investors and the “recency” effect. Photo: Getty Images
For all of the sophisticated measuring methods and tools investors have these days, the conversation was a reminder that what often sticks with people—meaning that they use it or live by it whether it’s right or wrong—are the simple rudimentary financial tools, rules of thumb that, financially speaking, feel like they go back to the time of the cave man.
The problem with these rules is the same as with anything that can be labeled “one size fits all.” It’s typically more like “one size covers everyone,” without regard to how good something looks and fits on any individual.
It’s not that these financial rules of thumb are tall tales or complete folly, but they have limited application as investment or money-management principles.
Here are the financial rules of thumb that the guys at the club asked about, and how I think they do or don’t apply today:
1. Subtract your age from 100 to determine your stock allocation.
This rule became popular in the 1970s and ‘80s with the emergence of retirement plans, as individuals tried to come up with a handle on asset allocation without necessarily trying to conquer the subject matter.
It has its supporters too, most notably Jack Bogle, the founder of the Vanguard Group (though it should be noted that he factors Social Security in as an asset of his portfolio on the fixed-income side, so he has always said his investment portfolio is not entirely calibrated to his age).
The problem here is that everything from life expectancy to age at retirement, from the 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, helping to account for the fact that people are living longer in retirement than they were when the rule was first promulgated.
2. Keep 5 % to 10% of your portfolio in gold.
Another relic of the 1970s—before asset allocation evolved to where investors could slice and dice the world into precise slivers—the idea here is that gold is a salve for uncertain economic times, a hedge against inflation, currency risk, and political and socioeconomic troubles.
As a result, this rule comes into or out of favor, generally based on how well gold is doing that job or how necessary that hedge is.
The classic gold allocation of 10% of assets was cut down to 5% when it didn’t seem to work so well over the course of the 1980s, and it continued to decline until going virtually extinct during the bull market of the 1990s. It re-emerged—perhaps as an alibi for chasing performance—as gold bounced back strong when the Internet bubble burst. From the bear market of 2000 through the end of the ‘00s—fueled by easier access and trading thanks to the emergence of exchange-traded funds–average investors and professional money managers moved back to the standard gold allocation, just in time for gold to crater and beat it back out of them.
The truth about this rule is that gold still has all of its traditional value as a hedge and an asset that does not perform in lock-step with the rest of the market. But the rule only works for average investors if they can ride it out and maintain their allocation in the worst of times—and rebalance their portfolio periodically when volatility in either direction pushes the gold allocation away from its target level.