The problem with financial rules of thumb: They are thrown out there as if they are an answer for everyone, when instead they are a one-size-fits-some solution.
When savers and investors settle for rules of thumb, you’d like to think they’re at least getting sound financial basics.
But a study released recently by Dreyfus showed that investors might be better off sucking their thumb than misguidedly following rules of thumb, because they weren’t sure how at least one common-sense rule actually worked.
The survey asked investors about the 60/40 asset-allocation rule, the common thought that most investors should allocate 60 percent of their investable assets to stocks and 40 percent to bonds, and nearly half of the respondents had no clue as to how this simple guideline actually worked.
Less than one in five respondents got the rule right, but more than twice that many thought the 60-40 represented some sort of split between long-term and short-term investments.
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Roughly two-thirds of the survey respondents also figured that 60/40 would not meet their needs and goals, suggesting that they would need more flexibility or more and different asset classes to hit their targets.
And therein lies the problem with financial rules of thumb; they are thrown out there as if they are an answer for everyone, when instead they are a one-size-fits-some solution.
“In the investable marketplace, there is no one-size fits all; each investor has different goals,” Dreyfus Vice President Joe Moran said. “The 60/40 rule, if you go back some time, probably had some general merit to it, because it was intended to be more basic, more easy to understand, and frankly 20 or 30 years ago markets were a bit simpler. As market have evolved and investors have evolved in where they can put their money, that’s where 60/40 rule has gotten a bit dated.”
The same could be said for virtually every financial rule of thumb, but the truth is also that in modern-day finance, many of the black-box and “robo” solutions are basically rules-based solutions with some flexibility built in.
The question is whether the rules themselves are worthwhile.
Beyond the 60/40 rule, here are the three financial aphorisms that readers and listeners ask me about most often:
• Subtract your age from 100 to determine your stock allocation.
This alternative to the 60/40 static allocation 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 supporters too, most notably Jack Bogle, the founder of the Vanguard Group (though it should be noted that Bogle 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 affect 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 becoming popular.
• Keep 5 to 10 percent of your portfolio in gold.
Another relic of the 1970s — before asset allocation evolved to where investors could lump gold into the “alternatives” portion of their portfolio — the idea here is that gold is a salve for uncertain economic times, a hedge against inflation, currency risk, and political and socioeconomic troubles.
That’s why this rule comes into or out of favor, generally based on how well gold is doing that job or how necessary that hedge is.
This rule nearly went extinct during the bull market of the 1990s but re-emerged when gold bounced back after the bursting of the internet bubble.
It became the excuse for chasing performance, as investors justified buying the hot asset by saying they needed to live up to this convention.
While gold retains its traditional value as a hedge and an asset that does not perform in lock-step with the rest of the market, this rule of thumb only works for average investors who can ride it out and maintain their allocation in the worst of times, and who rebalance their portfolio periodically when volatility in either direction pushes gold away from its target level.
That makes this less a rule than a choice; most average investors have discovered that they can build a winning portfolio — and sleep better at night — by ignoring this standard than following it.
• In retirement, a safe withdrawal rate is 4 percent of your portfolio each year.
This “rule” persists in the face of evidence that it shouldn’t.
Nobel Prize-winning economist William Sharpe in 2010 warned that this strategy is “fundamentally flawed,” because you could face a shortfall whenever risky investments underperform and have surpluses when the market works in your favor. In short, it emphasizes “sequence-of-return risk,” the chance that good or bad results early in your retirement years can dramatically change your finances for the rest of your life.
The 4 percent withdrawal is supposed to be adjusted for inflation, but studies over the last few years suggest that steady withdrawals, not adjusted for inflation, are a better bet.
The real problem here is that the “appropriate” withdrawal amount depends almost entirely on your ability to build a nest egg. As a result, this is more a target than a rule, something you shoot for while aiming to reach your savings goals.