My favorite personal finance book is Richest Man in Babylon. I love the book because it is a relatively quick read, with easily understood principles taught through parables. But there’s always been one thing that has stuck out to me. Multiple times through the author discusses savings rates, early on he writes, “A part of all you earn is yours to keep. It should be not less than a tenth no matter how little you earn. It can be as much more as you can afford.”
The author says to save at least 10% or as much as you can afford, but of course, what many people hear is, “if you save 10% and you’ll be just fine.” This same “10%” is tossed around multiple times throughout the book, unintentionally reinforcing this rule of thumb.
In my opinion, people use rules of thumbs to give themselves excuses to make the easy decision. It’s hard to save and easy to spend, so why not pick 5-10% and hope for the best? Most people blindly follow rules of thumb without giving them a second thought, but not us.
Let’s list out some great (sarcasm intended) rules of thumb, and why you shouldn’t base your financial planning around them:
Save 10% of your income
The good- it gets you saving, and let’s be honest, 10% is a lot more than the majority of people save.
The bad- why limit yourself to just 10%. You are financially independent when you have saved 25x your expenses. The more you save, the sooner you reach that threshold, imagine that! Why save just 10% if you could save 30% without negatively impacting your happiness, heck, what about 50%?
Next level thinking- save as much as you can! Or at least as much so you are not sacrificing your happiness and needlessly depriving yourself. Life is a balance, you need to live now, but also know that the more you save today, the less you need to save tomorrow. While you are “sacrificing” today, your friends will be sacrificing their tomorrows… for 30+ years!
The percentage of your portfolio invested in bonds should equal your age.
The Good- this will result in a less volatile portfolio
The Bad- Let’s say someone retires at age 65, this rule of thumb states that 65% of their money should be in bonds. The issue is, due to healthcare advancements, people are living longer. “That’s an issue?” you’re probably thinking. Well yes, that means that when you retire, you may very possibly need your portfolio to last you upwards of 40 years! That’s a long time for a portfolio that will be heavily invested in bonds to last. You’re essentially killing the beautiful thing that is compound interest for money you may not need for another 3-4 decades.
Be smart, and don’t adhere to this rule of thumb. There’s a good argument that no 30-40 year old should have ANY bonds in their portfolio, much less 30-40%… unless you like more money to grow slower.
***Disclaimer, 100% stock allocation will be more volatile, but volatility works in both directions. That means your portfolio has the potential to lose the most value in a recession, but also to have the largest returns in a bull market. On average, you’ll have a much higher return, and you’ll be much happier when your retirement day finally comes around, which will likely come much sooner if you decide to toss this stupid rule.
Next level thinking- think of your own individual circumstances and personality. First, consider, investment success is determined by investor behavior. Don’t believe me, check out this awesome study conducted by Fidelity. It turns out, dead people are really good at investing because they don’t sell at the bottom (even though you’re confident you can time it right). If you are confident that you are not a flight risk who will sell everything when the first sign of trouble hits the market, then you can stand to have a more volatile portfolio (aka, more stocks).
Next, if you are in your 30s and you don’t plan on retiring until age 50, then that is around 20 years until you need to access this portfolio. Why limit the growth during that period by investing in bonds, unless you are worried you might get nervous and sell during a recession? Even when you do reach age 50, you should not immediately shift 50% to bonds, remember you may well need that money for 50 years, so don’t take the foot off the pedal.
Save 20x your annual income for retirement
The Good- It turns people’s attention to retirement, and puts responsibility in their court, rather than just planning on Social Security paying the bills.
The Bad- This rule of thumb creates a false paradigm that actually leads to the biggest issue (in my opinion) in personal finance. This rule of thumb links spending to income when in all reality, spending and income are not at all connected. Just because you make $100K, that doesn’t mean you have to spend $100K. If I’m a person who makes $200K, but only spend $50K a year, why on earth do I need to save $4M? (Based on the 4% rule that would mean I could spend $160K in retirement despite current expenses of $50k)
Next level thinking- again, consider your individual situation. If you are planning on your portfolio supporting yourself 100%, then consider having 25x your expenses invested by retirement (the same as the 4% rule). Or, maybe you have a side business that you don’t mind continuing into retirement, you could consider retiring with less invested than 25x your expenses.
You can afford a house that is 2.5x-5x your annual income (Yes, I’ve heard that whole range)
The Good- this gives a reasonable range, especially the 2.5x-3x your income, for a home to purchase
The Bad- just because you make a lot it doesn’t mean you need a large, expensive home. If you are a doctor, you shouldn’t feel compelled to build a $1.5M mc-mansion.
Next level thinking- buy a house that fits your needs and allows you to accomplish your goals. While your primary residence should be a refuge and a place that you can feel comfortable, spending too much on a house requires you to work for decades just to afford the house, so in all reality, it becomes more of a prison.
When your car has xxx miles it is more expensive to repair it than get a new car
The Good- you’ll always have a cool car parked somewhere, not getting used 99% of the time
The Bad- you are going to lose so much money over the course of your life if you follow this approach. I once had a co-worker tell me he was going to get a new car soon because his current car was approaching 100k miles, so surely repairs would skyrocket any day. If you need proof, please see these awesome infographics made by ChooseFI.
Next level thinking- understanding the true cost of car ownership is key, as a car is likely the 2nd largest expense you will have. Driving used vehicles, and driving well past 100k miles will help you to retire years earlier than your new-car-buying counterparts.
Rules of thumb are helpful to a point. They’re helpful to give you a starting point, but as you can see, you should never trust any rule of thumb implicitly, before you think critically about how it applies to your own situation and goals.
But there are a few good rules of thumb that I wanted to point out.
The Rule of 72
This rule helps you to understand compound interest and how fast your money will double. It’s easy to use as well, you just divide your average annual investment return into 72, and that’s how many years it takes for your money to double.
So let’s say that you are assuming an 8% (72/8= every 9 years your money will double) annual return, and you have $100k invested at age 30. Let’s see how much that’ll be worth by age 60.
- 30- $100k
- 39- $200k
- 48- $400K
- 57- $800k
Not half bad. You make $700k on your money over 27 years and you didn’t have to work a second for any of it. “Don’t work for money make your money work for you.”
The 4% Rule
This rule was referenced earlier. This rule states how much money you should be able to safely withdraw from your portfolio every year, without it running out, and also factoring in inflation.
So if you retired with $1M invested, that means you could safely withdraw $40k a year in retirement.
This is the same thing as saving 25x your expenses (40,000 x 25= 1M).
Words of caution first, some people are calling the 4% rule too risky and say that you should actually scale this back to ensure you don’t run out of money in retirement, perhaps a 3.5% or 3% withdrawal rate. But if you can be flexible in retirement and be able to cut spending during years when the market is down, the 4% rule is much more likely to pan out.
Second, when people hear this rule they will want to use this to plan out how much they need to have invested for retirement. So let’s give a hypothetical case. I’m 30 with no current investments. I want to have a retirement income of $75k and I plan on working for 25 more years. That means I need to save enough to have $1.875M by age 55. Perfect! That means if I save X amount per year I’ve got it!
Did you catch the issue there? People have a bad habit of disregarding inflation in their retirement planning. You may be able to live off $75k today, but in 25 years, $75k will be worth a fraction of what it is today.
Now you can correct any of your well-intentioned friends when they lightly toss around any of these Rules of Thumb.