Someone once told me, “A good rule of thumb is to avoid using rules of thumb.” While rough guidelines for what constitutes “normal” in certain areas can be helpful, some rules of thumb can also be harmful at times. Here’s a list of 3 rules of thumb that investors can often ignore.
1. Buy a house with a mortgage 2.5 times your annual income.
With residential real estate showing signs of life again, interest in “moving up” is increasing. This age old rule of thumb is a very broad generalization that may be fine for some. Others, however, particularly those with unstable incomes; high levels of credit card or student loan debt; or uncertainty about job situations may want to take a step back from the ledge. A house provides shelter and may end up as a reasonable storehouse (meaning staying with inflation) of value over many years. The most important part of that formula, however, is the number of years you live there. Having a maximum mortgage just so you can try to leverage the anticipated upswing in housing values is a high risk strategy. It leaves you exposed and vulnerable.
2. Never withdraw more than 4% per year from your portfolio in retirement.
Again, a reasonable starting point but what the appropriate withdrawal or spending rate might be is hugely dynamic and highly personal. The starting point is to realize that income needs in retirement years vary one to the next. This is fine if you understand that investment returns also vary from year to year. For some retirees with well diversified portfolios mostly invested in equities, a withdrawal rate north of 4% might be fine in years where returns are well above normal. The main caveat, however, is this is wholly dependent upon a willingness to reduce the withdrawals in periods where returns are negative. Most investors can live with this but certainly not all. Flexibility is rewarded.
3. Save 10% of your income
We all like nice even numbers and that likely has more to do with the 10% rule of thumb than anything else. With retirement income “needs” and life expectancies both increasing, 10% is likely well below what the math provides as an answer to the retirement equation. Yet another factor is later household formation (marriage) and career changes that may challenge savings in early years. To fund a retirement that might stretch 30 years or more, saving 10% in tax-deferred and 10% in taxable accounts is much closer to reality.
The common thread flowing through all of these is to understand generalizations, rules of thumb, may apply to some but perhaps not to you and your goals. Stay focused on the long term (stay invested), and avoid mistakes.