6 Financial Rules of Thumb to Avoid

James debunks six popular rules of thumb that can actually do more harm than good when it comes to retirement planning. 

From the 100-minus-your-age stock allocation rule to the 70% to 80% income replacement myth, James breaks down why rules like these can be counterproductive and suggests alternative strategies that will help you create a personalized financial plan that meets your unique needs and goals. 

Questions Answered:
Which rules of thumb should not be universally applied?
What can you do instead?

Timestamps:
0:00 Introduction
2:36 The First Rule
5:57 The Second Rule
9:04 The Third Rule
11:48 The Fourth Rule
14:04 The Fifth Rule 
18:08 The Sixth Rule
20:09 How to Measure Risk
22:02 Outro

Create Your Custom Strategy ⬇️

Get Started Here.

Join the new Root Collective HERE!

Transcript

 Financial planning can be complicated. You have to know details about taxes, about investments, about insurances, budgeting in a lot, a lot more. And because of this, we try to look at this big confusing thing called finance and create some rules of thumb. Now, some of these rules of thumb are helpful, but many of them actually turn out to be counterproductive.

So today what I want to do is I'm gonna walk you through six rules of thumb that you should avoid, and I'm gonna share with you what you should look to do instead. This is another episode of Ready For Retirement. I'm your host, James Conole, and I'm here to teach you how to get the most outta life with your money.

And now onto the episode, finances can be hard on top of just the financial things you need to know. There's also the non-financial considerations and there's the application of even if you're the smartest person in the world with these financial topics, how do you actually apply them in different ways and in different situations?

That's what we're gonna cover today. Because if you look around, it seems there's so much that you should be doing or so much that you shouldn't be doing, and it can seem impossible to fully wrap your heads around it all. But because our brains don't like this chaos, our brains don't like just acknowledging, Hey, this is complicated and there's nuance to everything.

Our brains try to create some sense of order. It's what we do across the board in all different types of disciplines. And in doing this, we sometimes clinging to what you can call a rule of thumb, and some of these rules of thumb are good. But many aren't. So in today's video, we're gonna go over six rules of thumb that I believe you should not adhere to, and I'm gonna walk you through what you should do instead.

Before we do so though, I want to quickly highlight the review of the week. Really appreciate all of you who have taken the time to leave a five star review. Even. Leave a comment. That's how a lot of people find this show. And every month, more people get to find the show, which means every month more people get good, practical, useful information that will help them to create the retirement they dream about.

So the review for this week comes from Nina w. Nina reads this five stars and says, ready for Retirement is one of the best financial podcasts, and I look forward to every new episode. Every week James covers an important retirement topic clearly and concisely. My favorite aspect of the show is that he uses real life examples to illustrate the concepts he teaches.

Thank you, James, for sharing your knowledge and making what can be a complicated topic accessible to the masses. Nina, thank you very much for that review, and if you're listening and have not yet left a review, please go ahead and do so. Would mean a lot to me. It'll mean a lot to people who are looking for good retirement content as they look for shows to find that on.

So let's now jump in. We're gonna go over six rules of thumb. That can be true in some senses, but should not necessarily be universally applied. Number one, the first rule of thumb that I'm actually gonna call this one pretty useless, is subtract your age from 100 and the resulting number is the percentage of your portfolio you should invest in stocks.

Now, what's the intent of that? The intent of that rule of thumb is that your portfolio should become less risky the older that you get. So for example, if you're using this rule, start with a hundred. If you're 30 years old, you would say 100 minus 30. That gives you how much you should have in stocks. So 70.

So 70% of your portfolio should be in stocks according to this rule, versus if you're 60 years old. You would take 100, subtract 60, and that would give you 40. So 40% of your portfolio should be in stocks. So, Again, the intent is to say, how do we make our portfolio less risky, the older that we get, and the closer that we need to start spending down this money?

The problem with this is, number one, your portfolio gets way too conservative, way too quickly with people living longer and longer, and by the way, people say, oh, life expectancy may be 78 or 79. So if I retire at 65, I may able only have 13, 14, 15 years. Well, that's life expectancy. When we're looking at that 78, 79, that's life expectancy from the day that you are born, which means if you've actually made it to 65, You have a much longer life expectancy than that.

If you're married in, say you're both 65 for example, there's a very good chance at least one of you will live past age 90. Why is that relevant? Well, this is relevant because as you look at this rule of thumb of start with your age or subtract your age from a hundred in the resulting numbers of percentage of your portfolio, you should invest in stocks.

You are gonna have a very conservative portfolio, and one of the biggest risks that you're gonna face in retirement is not getting enough growth to keep up with inflation. Over potentially a 20, 30 plus year retirement. So the goal of this rule of thumb is to come up with a simple solution for how much did you have in stocks and how much did you have in bonds?

At a very basic level, the problem is this simple solution's probably a very bad solution for most people. Instead of subtracting your age from some arbitrary number, And by the way, some people will say, well, no, it's not a hundred that you start with. It's 120. So subtract your H from 120. So in this case, if you are 50 years old, you would say, okay, one 20 minus 50 equals 70.

But regardless what the starting number is, it's just arbitrary and there's no way that simple rule of thumb can apply to everyone the same way. What should you actually do? Well, what you should actually do is determine what will your needs be from your portfolio. Your portfolio shouldn't just be based on a 60 40 portfolio or a 70 30 portfolio or start with a hundred and subtract your age portfolio.

It should be based upon what do you need from this, and do you have enough stable, secure investments to give you the income you need if the market is going down? And do you have enough growth oriented investments to protect against inflation risk over the rest of your retirement, over the rest of your life?

So don't just start with a rule of thumb like this. This can be horribly ineffective and actually counterproductive in many cases. Instead, understand your unique needs from your portfolio and design a specific allocation of stocks and bonds around that. The second rule of thumb that I believe is not super helpful is by term life insurance worth 10 times your gross annual income.

Now, to be fair, this isn't a horribly counterproductive rule of thumb. It can actually be a good starting point if you're just trying to figure out where do you begin. But when you look at this, you have to realize that your need for insurance. Is not static over the course of your lifetime. Let's say that you're 30 years old, you just got married, you have a kid, you have a mortgage, and one spouse stays home.

Well, in that case, you probably need a pretty significant amount of insurance because if the working spouse passes away, there's a mortgage to pay, there's a child to feed, there's a surviving spouse that needs to be cared for that probably doesn't want to jump right back into the workforce right away.

There's probably a specific amount of insurance that's needed. And in general, you probably want enough insurance to pay off the mortgage and to have enough left over for the surviving spouse to live on for a number of years, as well as enough left over to set aside and invest for retirement years because there's no longer contributions going to a 401K or investment account for retirement.

So you may actually need much more than 10 times your annual salary at that point. Well then fast forward 30 years, let's assume that same couple is now 60 years old and they've had some children, but the children are grown. They're financially independent. The parents are no longer supporting them. That mortgage that they had is now paid off.

Their portfolio is a lot larger because they've been disciplined about putting money into their 401k investments over the course of a lifetime. Well, by the time that you're 60, there's not a rule of thumb for how much insurance do you need. It really comes down to what would happen. To the surviving spouse, to either surviving spouse if one spouse passed away.

Now, of course, it'd be tragic, but I'm not asking how tragic would it be. I'm asking what would the financial impact be if the surviving spouse would not be able to get by financially if their spouse passed away? There's still a need for life insurance. However, if you look at that and say, okay, well between the investments we have invested and accumulated and compounded over the years in the social security benefit and the survivor benefit and some cash that we have, and the fact we have a paid off home.

I'm just making up details here, but if you are at a point where you look at that and say, yes, it'd be tragic if one of us passed away, but the surviving spouse would not be in a financial bind. What? You really don't need any life insurance at that point. You can consider buying some or keeping some just for peace of mind, but keep in mind that is purely something that you're doing for peace of mind, not because it makes sense financially or is necessary financially.

So as you look at it, yes, getting a policy worth 10 times your gross annual income can be a fair enough assessment of your insurance needs, your life insurance needs earlier on in your life. Now, in many cases, it might not be sufficient, but where I see this rule of thumb actually being irrelevant is the older you get, assume you've done a good job of saving and investing.

Your need for insurance really goes down. And at some point it goes away. So I see a lot of people in their sixties still carrying life insurance and they're paying for it, but they don't necessarily need to be. It's just been ingrained in their head that they always need to carry something to protect their spouse or to protect their family.

So that's something that should be looked at on a case by case basis as opposed to just applying a simple rule of thumb. The third rule of thumb that is not particularly useful for everyone is when you hear experts say, save 10 to 15% of your income for retirement. Now I need to catch myself. Sometimes when I say this is a useless rule of thumb, because the reality is if you have no idea where to start and you're saying, look, I'm getting my first job, or I'm saving for retirement, what should I do to my 401k?

You're probably not gonna go wrong by choosing a number like 10% or 15%. However, you have to keep this in mind. Every dollar you put away for retirement is one fewer dollar you have for current needs. So when you're younger, those current needs might be saving for a home. It might be saving for college, it might be enjoying life with your spouse or with your family or doing other things.

And as you get older, those other things might just be lifestyle. You cross a point at which you are financially independent, which means if you've been saving and investing your 401k, or really any investment account for the large part of your career, you reach a point at which you have enough in your portfolio.

And so if you continue to do 10 to 15% for retirement, is it a bad thing? No, not necessarily. Only if you're giving up other things, that would be even better. For example, if you're continuing to max out a 401k and save quite a bit, but you're saying no to travel or you're saying no to friends, or you're saying no to things that would be enjoyable for you and your spouse, well there's a cost for that.

And so if you're just applying this 10 to 15%, you might be overs saving in some examples, and the opportunity cost of that shows up in a non-financial way. In other instances, 10 to 15% might not be nearly enough. If you're 60 years old and you haven't saved a dime for retirement and you're trying to retire by 67, 68, Well, saving 10 to 15% might not be nearly enough.

So as you look at it, sure, that's a good place to start if you start saving and investing at a very specific age. But you have to look at what are your future needs in retirement that you're saving and investing for, and how much of a portfolio do you need to support those needs? And then really back into what is the specific savings rate that works for you.

For some people, it's only five or 6% because of what they've already done or what they already have. For others, it's 2025, 30% if they had a late start or if they're really trying to save for an amazing retirement, really luxurious retirement. So keep in mind that, yes, that can be a good place to start, but you do want a savings rate that's unique to you, so you're not sacrificing your future, nor are you sacrificing your today.

Hey everyone, it's MIA again for the disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal, or other financial advice. It is for informational purposes only.

The fourth rule of thumb that I recommend people try to avoid is the 4% rule. Now, there's two reasons for this. The first of which, if you've been listening to this podcast for any period of time or if you've been looking or watching our YouTube channel for any period of time, you already know what I'm gonna say.

You're gonna say, oh, yes James. We know there's a different approach, guidance approach. You have a more dynamic withdrawal rate than you can take out more than 4%. Yes, absolutely. But even outside of that, the second reason for this is most people don't have a static withdrawal rate throughout retirement.

I just did a podcast on this. It was one or two, maybe three episodes ago. I forget off the top of my head. But what I talked about was the fact that in retirement, very rarely do you have one specific withdrawal rate, and then simply adjust that for inflation over time. You might have staggered income sources in retirement.

Meaning you retire, but your social security doesn't kick in for a couple years. Maybe your spouse's social security doesn't kick in for a few years after that, or you have staggered expenses. Maybe you're still paying a mortgage the first few years of retirement, and maybe you're traveling the first few years of retirement, but expenses drop after that.

Well, when you look at staggered income and staggered expenses, when you combine that with the fact that for most people in general, they're spending a lot more in the first several years of retirement, call those the go-go years, but then there's a slow go years and the no-go years later on where your expenses just naturally start to change.

What you realize is it's not just looking at your portfolio and saying, okay, I'm gonna take 4% outta this. Forever as if it's just a smooth, unchanging, upward sloping line that adjusts with inflation. Now the reality is your portfolio exists to supplement what's coming from social security or pension or rental income or inheritance, or a part-time worker, any other income sources.

So because it exists as a supplement, it's not gonna be the same exact amount every single year. So if you're just looking at your portfolio from that standpoint, you might miscalculate how much you actually need to retire, or you might miscalculate the sustainability of your portfolio. So instead of just looking at one specific withdrawal rate, try to get a general sense of how will that change over time, because that will have implications in terms of how much you need in your portfolio to retire and whether spending more in some years than others is sustainable versus will that result in you spending on your portfolio too early.

The fifth useless rule of thumb is this, it's the long term average. The US stock market is 10%. Now the funny thing is, that's a stat I talk about all the time. If you go all the way back to the mid 1920s, the s and p 500 has averaged just over 10% per year growth. So it's an entirely true statement.

However, it's a totally useless rule of thumb. Why do I say that? Well, when you say that, You start to get the impression that, okay, every year, more or less, the s and p 500 goes up by about 10% per year. Well, here's the reality. The s and p 500 has literally never returned exactly 10% per year. And on top of that annual returns over the last 95 years.

Annual returns have come within two percentage points of the market's, long-term average of 10% in only six years, meaning in only six outta the previous 95 years did the s and p 500 return between 8% and 12%. In other words, 89 out of 95 years, did it return less than that? So less than 8% or greater than 12%.

To give more perspective, yearly returns have ranged as high as up, so a positive return of 54% to a low or a negative return of down 43%. And since 1926 in your returns have been positive 70 times in negative 26 times, why does this matter? Well, this matters because if you use the US market returning 10%, as a rule of thumb, you're probably gonna be fine if you're trying to project out just a basic understanding of what might money, money grow to, if I'm invested in all stock portfolio.

Over the next 20, 30, 40 years. However, if you're using that to determine how am I performing year in and year out and how am I performing relative to this 10% benchmark, it's horribly useless because you're probably not, you're almost certainly not gonna get exactly 10% every single year. So if that's your expectation going into investing, you're going to be set up for a bad experience.

When you start to realize that many years, one outta four years on average, you're actually gonna have a negative. Performing year. A quick add on this one thing I hear when I'm doing these podcasts, or especially on YouTube, people will comment, I'll talk about, uh, growing by 8% or 6% or 10% or whatever.

It's, and a common comment is how can you talk about that growth rate in this market environment? Well, what does this market environment mean other than looking at what happened last year and maybe even the first couple, few months of this year? Really what people are saying when they're talking about this market environment is they're talking about something that already happened.

Now, if you knew for certainty, we're gonna have a negative year going forward again. Sure talk about it, but so many times what we're looking at is this market environment simply means what's happened recently. And because we're wired to be such short-term thinkers, if the market's going up like crazy while we fall into the trap of thinking this will continue.

If the market's gone down over the last 6, 12, 18 months, we look at that and say, oh, this is a horrible market environment. This is a bad time to be an investor. We're essentially taking what's already happened and extrapolating that under the future, and that's just because of our own behavioral biases.

That has nothing to do with what's actually gonna happen in the market. This is why so many people tend to underperform the market over time. They look at what's happening. They look at the downturn, they look at recession concerns, inflation concerns that you fill in the blank concerns, and they change their investment strategy.

And they say it's based upon logic. They say, oh, it's because I've researched this. I know it's coming. The reality is, is it's fear-based and you make a decision that ends up most of the time costing you because then the market recovers. So when you look at a market average and think that's the benchmark for how we should be performing each year, you set yourself up for failure.

Versus when you look at a market average and say, this is useful understanding for how much a portfolio might grow over time. However, I have the expectation that my portfolio could be up as much as 50% or down as much as 40% in any given year. That's a more appropriate way to look at it. Now, the sixth and the final useless rule of thumb is this.

It's stocks are risky, bonds are conservative, so this is conventional thinking, but it's not. Correct. Now it's correct. In one sense, it's correct if you're looking at risk as defined by standard deviation. Now, what is standard deviation? Standard deviation is simply the uncertainty that you can expect if your portfolio's gonna have an average return of some rate of return.

Well, to what extent are returns gonna come close to that average? The larger the standard deviation? The larger your returns are gonna deviate in an annual basis. So for example, if you have a portfolio that generates a return of 6% with a standard deviation of zero, it means you're getting 6% every single year.

So that's an extremely consistent return. Now, unfortunately, it doesn't exist, but that's what it would look like. Versus if you have a standard deviation of. 15. Well, that means that your average return might be 6%, but in an average year you might be down as much as 25% or up as much as 35%. So very little consistency.

So if you're looking at risk as measured by standard deviation, then it is true the bonds are less risky than stocks. However, I don't believe that standard deviation is the most appropriate measurement for risk. The first reason why is for people that talk this way or think this way, and, and by the way, it's a majority of people and not because, uh, there's anything wrong with them.

That's just conventional wisdom. But let me ask you this. I, if you think that's the case, tell me what is the standard deviation of your portfolio? Chances are, you have no idea I, I don't know what the standard deviation of my portfolio is. Now. I could look back over the last 2, 3, 5, 10 years and calculate it and tell you, but the reality is I don't actually care.

And even for clients, it's not a major concern. It's not something that we're reviewing on an annual basis of, Hey, Joe and Sally, here was the performance of your portfolio. Here was a standard deviation. Why? Because people don't actually care either. What they actually wanna know is, am I gonna be okay?

And how do I measure? Am I gonna be okay? It's, do I have enough money in my portfolio that's not gonna fluctuate with the stock market. So it's gonna stay very stable to meet my needs, even if there's a 20, 30, 40% downturn in the stock market. But more importantly, am I going to grow my portfolio in a way where it's gonna keep up with inflation so I can continue to meet my needs five years, 10 years, 20 years in the future?

So standard deviation is one way to measure risk if we're looking at the short-term fluctuation of your portfolio. But the biggest risk most retirees face isn't that short-term fluctuation. It's the long-term erosion of purchasing power. If you consider the over the course of a 30 year retirement, the cost of everything you purchase will likely go up 250% or more simply due to inflation.

Your real risk is not keeping up with inflation. And in that respect, when you look at long-term returns of bonds versus stocks, I would argue that stocks are actually less risky, number one, because even if you look at worst case scenario over 10, 15, 20 years, worst case scenario in stocks starts to actually look more attractive than worst case scenario for bonds.

But number two, stocks are growing to an extent, assuming you're properly diversified. To mitigate the long-term risk of inflation and the impact that that will have on your plan. So as you look at these rules of thumb, some of them are good from the standpoint of they give you a place to start, but as I mentioned at the beginning, finances are confusing, finances are chaotic.

There's so many different considerations and applications that you need to be aware of that we too often look at this and say, let's simplify all this chaos. And distill it down to a few basic rules of thumb. So while those can be an okay place to start, I really want to make sure that you understand the nuance and the application of these so that you can make the most of your portfolio and your planning as you look at your specific retirement.

So that is it for today's episode. As I mentioned at the beginning, please leave a review for this episode or this podcast if you're finding any value in it. And if you want other content like this, be sure to check out our YouTube page. It's Under Root Financial where you can get these episodes as well as additional video content to make sure that you're making the most of your retirement.

Thank you as always for listening, and I'll see you next time.

Thank you for listening to another episode of the Ready for Retirement podcast. If you're enjoying the show, please subscribe and let me know by leaving a five star review. And as always, for list of the notes and the resources mentioned in today's episode, you can find those at the Ready for Retirement website, which is ready for retirement.co.

That's ready for retirement.co. And if you have a question that you would like for me to answer on a future episode, then you can also go to the Ready for Retirement website ready for retirement.co. And there's a page called Submit Your Question where you can submit a question for me to answer in a future episode.

Thanks as always for listening, and I'll see you next time.