5 Financial Rules of Thumb You Need to Break
One of my favorite Seinfeld episodes is when Kramer storms into Jerry’s apartment and starts complaining about another golfer who picked up his ball in the middle of the fairway to clean it.
Kramer goes on to say that he penalized his friend a stroke for breaking the rule.
Elaine then asks, “What is the big deal?” and Kramer replies, “Hey, a rule is a rule, and without rules there’s chaos.”
The same can be said for personal finance.
Without money rules, chaos can ensue. However, there are some rules of thumb I believe you should be breaking if you want to get ahead.
Some rules are outdated, and some simply don’t apply to everyone’s individual financial circumstances. So why bother follow a rule that makes no sense?
Here’s my list of 5 financial rules of thumb you should consider breaking:
1) Use Your Age to Determine Asset Allocation
During the 1980s and 1990s, it was standard to give the following asset allocation advice:
“Subtract your age from the number 100 and that is the percentage of your portfolio you should have invested in equities, with the remaining percentage in fixed income, adjusted each year as you age.”
Under this rule, at age 30, for instance, you should keep 70% of your portfolio in stocks and the rest in bonds and other relatively safer securities. At age 65, you invest 35% of your assets in stocks.
The idea behind the rule is to gradually reduce investment risk as you age. But that doesn’t always work. Americans are living longer and retiring later.
Your retirement savings strategy should be adjusted to meet a bigger nest egg. At the same time, the yield on a 10-year Treasury Bill is roughly 2.5%, down from a peak of nearly 16% in the 1980s.
And with the stock market soaring over the past decade, it might not have made a lot of sense to dump a large portion of money into fixed income when you could reap greater gains.
My advice, rebalance your portfolio each year, look at your target retirement age, what you plan on using your funds for in retirement and your risk tolerance.
2) Pay Off Your Mortgage as Fast as Possible
For most, a mortgage is the largest debt they’ll ever owe. So from a risk tolerance point of view, it makes sense to want to pay down the debt as fast as possible.
Although this really only makes sense when interest rates are outpacing the stock market. If interest rates are double digits and investment returns average 7%, yes, it makes sense to pay down your mortgage faster.
But, the majority of homeowners today have a mortgage rate of less than 5%, and are seeing average annual returns above 7%.
So it’s better to make your payments on time, take your mortgage interest deduction on your federal income taxes and have more money invested for higher returns.
3) You’re Throwing Away Money If You Rent
Owning a home is part of living the American dream. And there’s been long held debates over whether or not renting is akin to flushing money down the toilet.
The way I see it, you have to live somewhere and renting affords you a life free of many of the unpredictable expenses homeownership offers. Not having to pay mortgage interest, property taxes, maintenance and repairs can be a big plus if there are good opportunities to put your money to work elsewhere.
Renting also means you have the flexibility to move to where opportunity exists. If you’re tied to a home, you might not be able to pick up and move to a more lucrative job opportunity in a neighboring state.
Obviously, there are benefits to owning a home too, so take this advice with a grain of salt.
4) Spend No More Than 30% of Your Income on Housing
The 30% rule is a common budget benchmark for housing costs. The gurus tell you to cap your rent or mortgage at under 30% of your monthly income.
This rule of thumb stems from housing regulations from the late 1960s. A US Census Bureau study said the Brooke Amendment (1969) to the 1968 Housing and Urban Development Act established the rent threshold of 25% of family income in response to rising renting costs.
The rent standard later rose to 30% in 1981, which has since remained unchanged, according to the study.
But this 40 year old standard may not be realistic for a lot of people today. A Harvard University study found in 2015, nearly 21 million renters — almost half of the country’s renters — spent more than 30% of their income on housing across the country.
Rather than think 30%, think what can I afford? Look at how much you earn, how much debt you owe, and where you live, your rent could be more or less than 30% of your paycheck.
If you find your rent is eating away most of your paycheck, consider ways of making more income or consider moving somewhere with lower costs.
5) Withdraw 4% of Your Savings In Retirement
When you retire, it’s been said you should start withdrawing 4% from your portfolio in your first year of retirement, increasing withdrawal each year enough to cover inflation.
If you have $2 million saved, you would take out $80,000 for the first year. If the annual inflation rate is 2%, then you withdraw $81,600 the following year ($80,000 plus 2%). And you continue this trend for the next 30 years.
This rule was created on historical data by financial advisor William Bengen in 1994. Where this rule falls short is it doesn’t take into account life’s ups and downs.
Your investment performance might lag one year because of a poor market or economic conditions. Bengen also assumes retirees have a portfolio split between stocks and bonds. He later revised the rule to 4.5%, using a more diversified portfolio.
My advice to you is be flexible and revise your spending rate based on your needs and portfolio performance. Early retirees might have a smaller nest egg, and need to withdraw less than 4% to make their savings last.
And someone with major health concerns and a shorter horizon might want to enjoy more of their savings with the time they have left.
As you can see there is no one-size-fits-all book of rules for personal finance. Use money rules as guidance, but use your best judgement on whether or not a rule should be broken or not.
To a richer life,