Financial & Estate Planning

Practical Finance: Rules of Thumb to Forget. Number One….

PRACTICAL FINANCE

RULES of THUMB to FORGET. NUMBER ONE….

If you saw the movie, The Big Short, you may remember a quote attributed to Mark Twain near the beginning of the show: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

After 47 years of advising clients, we notice that some of these rules of thumb which circulate in the world of personal finance have amazing staying power, even when they have little relevance to a family’s actual circumstances. Recently our firm’s Wealth Planning Committee, conducted an informal poll among our Wealth Advisors to ascertain which of these seem most widely embraced. Phillip Hamman, CFP, CFA who chairs the committee said, “We reached a pretty good consensus on a “Top Five” — no small feat considering the diversity of our group that includes CPAs, JDs, and other credentialled professionals from multiple backgrounds.” We’ll touch on number one in today’s post.

NUMBER ONE: Your invested asset allocation should relate inversely to your age. There are several iterations to this one, but the most popular version is, “Your allocation to stock market investments should be equal to 100 minus your age (40% equities at age 60, 30% equities at 70, and so on)”. This describes a glide path of declining exposure to stock investments as you age during retirement.

All rules of thumb are not bad, since they can help simplify things that are complex. However, this is one that is ready to be retired itself. The original underlying premise of this rule of thumb is based on a mathematical truth – the older you are, the less time you have remaining to recover from a bear market in stocks.  While true, age is only one factor that enters into the asset allocation decision. This rule of thumb overlooks all the interrelated personal financial planning factors that can make a difference in comparing one family’s situation with another’s.

There is actually a great deal of academic research on this subject of setting appropriate asset allocation as circumstances evolve during one’s lifetime, and particularly during the retirement years. It is important to realize that allocation policy and time horizons can span generations and the tax treatment of different types of investment accounts figures into final decisions.

Perhaps a couple of practical examples will illustrate the more obvious point on the pitfalls that can lead to oversimplifying a complex question.

  • Example One: You are retiring early at an age like 55. The rule of thumb noted above might suggest 45% in stocks with the remainder in conservative investments. However, assume you are setting allocation for investments in an IRA Rollover account that will likely sit untouched until you begin Required Minimum Distributions at age 70-1/2, because you have other identified sources of early retirement cash flow. In such a case, you have a lengthy time horizon and an allocation of 45% to stocks is very likely overly-conservative for such a pool of money.
  • Example Two: You consider yourself “mid-career” with 20 years remaining to retirement. Considering time-horizon alone, your allocation to stocks under the Age 100 and similar rules of thumb would suggest heavy allocation (some even 100%) to stock investments. However, you contemplate college expenditures for children in the next five years and also aspire to purchase a vacation home soon to enjoy during the early years of empty nesting. These diverse objectives which will affect the drawdown of your assets might certainly dictate some reasonable measure of conservative assets.

Rules of Thumb may be a good starting point for examination of particular financial issues. But take care, as they can often be clever oversimplifications.