To research this post, I Googled “Rules of Thumb”. Most of the results were 8 or even 10 Rules of Thumb. That seems like a lot to digest in one post, so I will discuss 4, all related to investing, money management, and asset allocation.
Rule of 72
This one is pretty well-known. It relates to how long it takes for an investment to double in value. The easiest example is an investment that earns 8% will take 9 years to double, an investment that earns 9% will take 8 years to double. 8 times 9 = 72. If you only earn 4%, it will take 18 years to double. This assumes compounding of returns. This is one reason investors are favoring equities. With returns on fixed income securities as low as they are, investors are seeking a shorter time for their investments to double in value. Do the math yourself. The Rule of 72 us a rough estimate but it is very helpful.
120 Minus Your Age
This is an estimate of how much of your portfolio you should allocate to equities. If you are 50 years old, this rule says you should allocate 70% of your portfolio to equities, and the rest to safer investments such as cash, cash equivalents, and bonds. If you are only 10 years old, you should borrow 10% of your net worth and stick it in the stock market (just kidding!). I like this because it illustrates that you should keep a relatively large percentage in equities even when you are over 50 years old because you are probably going to live many more years and you will need the money. It also reflects that equity returns have continued to exceed returns on fixed income investments and older investors will need the equity returns as they get older.
Save 20 Times Your Gross Annual Income
If your gross annual salary is $100,000, this Rule posits that you need to have $2 million in the bank when you retire. If your salary is $200,000, then you need $4 million. You can achieve a good chunk of this by following my advice in my 401k Millionaire post from May 11, 2018. For the remainder, you have to discipline yourself to save more. The alternative is to keep working after you “retire”, or file for Social Security well after your full retirement age, or to put your investments in income or dividend-generating securities such that your cash flow needs will be met and you will live comfortably.
This Rule of Thumb states that, once you retire, you can withdraw any earnings on your investments plus up to 4% of your principal and still continue to live comfortably and keep enough money for your future. If you had a bad year last year and you didn’t make much or even lost money in your portfolio, then you will have to make some cuts this year. Too bad our governments don’t abide by this!
Ok, I will bullet-point some others:
- Don’t buy a new car unless you are planning to drive it for at least 10 years.
- Only borrow as much in student loans as you are planning to make as an annual salary during your first year out of college.
- Don’t buy a house that costs more than 3 times your annual gross salary. This is very difficult in most cosmopolitan areas.
The point of these Rules of Thumb is to incent investor discipline. They give you some shape and guidance around what you are trying to do. I’m sure there are other Rules of Thumb that you may live by that I haven’t covered here. What are some of your Rules of Thumb? Please email me and I will consider writing about them.