Rules of thumb are often used to make various financial decisions. While they can be helpful when it comes finding a starting point, rules of thumb should be approached with a degree of skepticism.
Circumstances — And the Markets — Change
Many rules of thumb are based on a specific set of circumstances. The rule of thumb that states that it makes sense to spend 30% of your income each month on a housing payment doesn’t take into account the fact that you might have other debts, and that taking on more might over-leverage you.
Another difficulty has to do with the fact that rules of thumb related to stock market returns don’t always work out, either. The 10-5-3 rule suggests that, over the long haul, the stock market returns 10% a year, bonds 5% a year, and cash 3% a year. But if you’ve seen the markets during the last four years, you know this isn’t the case. If things go south in the years immediately leading up to your retirement, and during the first years of your retirement, counting on those types of returns can be problematic.
And what about the 4% withdrawal rule? This rule of thumb says that you can withdraw 4% of your nest egg each year without tapping into your capital. The result is that your money will last indefinitely. However, this rule of thumb presumes a 7% annual return while assuming that inflation is 3%. As long as circumstances and markets act in this predictable manner, there is no issue. Your money really can last forever.
But What If Things Change?
Your circumstances might change. If you lose your job, or encounter another financial setback, 30% of your income might be too much to handle for a mortgage payment — especially if you have other debt. What if you estimate your retirement based on how much you are able to save, but a job loss means you can’t set aside money anymore, plus you lose your employer match?
Markets and economic conditions change as well. The market might not return what you expect each year. Economic conditions might lead to greater inflation than expected. While of these issues are smoothed out over time, especially if you have a 30 or 40 year timeframe, the reality is that timing can make a big difference. If a big stock market crash wipes out half the value of your nest egg two years before retirement, it can be very difficult to recover.
So, What Can You Do?
Rules of thumb can be useful in terms of starting points for deciding on what to do next. While it’s nice to think that stocks offer 10% annualized returns over 20 years, the reality is that the S&P recently only returned 7.89% over a 20-year period (according to the most recent DALBAR survey). Instead of basing your future plans on something like the 10-5-3 rule of thumb, moderate your expectations. When take a conservative approach, you are more likely to succeed in the long run.
If you are buying a home, start with the 30% rule, and then evaluate where that puts you in terms of finances. If you bring home $4,500 each month, are you truly comfortable with putting $1,350 of it toward a mortgage payment? And what happens when you add in property taxes, utility, home insurance, and maintenance? The costs really start to add up. Consider keeping all of your housing costs to 30%, or even adapt the rule so that you only get a mortgage that is 25% or less of your regular income.
Instead of just buying 10 times your annual salary for life insurance, sit down and figure out what your really needs are. Use the 10 times rule as a starting point, but then add or subtract from it, depending on what you really need, whether you need more coverage to pay off debt, or whether you need less coverage because your life partner works, and won’t need the life insurance pay off to completely support him or her.
If you don’t know where to begin, a rule of thumb can provide a point of reference. However, you shouldn’t rely entirely on rules of thumb. Instead, really think about your individual situation, and make choices based on the possibility that things could go wrong.