Wouldn’t it be great if following just a few “one-size-fits-all” financial formulas could really make planning for a successful retirement less of a problem?
Unfortunately there is no such thing.
Oh, sure, there are theories and guidelines and strategies. And some can be useful as a starting point for financial planning. But there are also some common rules of thumb that can point retirees in the wrong direction, leaving them in for a bumpy future.
And this is not just because we are all different, with different challenges, goals and salary. (Although that’s a big part of it.) But there’s also this: The world around us continues to change, and those long-accepted approaches to investing and income planning often need updating.
Here are three investing and retirement “rules” or strategies that you’ve probably heard of, along with the reasons they might not work for you.
The 60/40 rule
Regardless of their goals, risk tolerance or other relevant factors, investors are often told that a generic ’60/40′ portfolio mix (with about 60% invested in stocks and 40% in bonds) is the best way to go while they’re at it. . still working and saving for retirement. And I get it: it’s safer than betting too much on stocks. But that conservative 60/40 mix could also potentially turn portfolio growth into years when owning more stocks can make sense.
Then, when those investors retire, financial professionals often suggest moving even more of their money into bonds — because “when you’re older, you need to be more careful.”
While these bond-heavy allocations may have worked out fine in the past—when interest rates were much higher and inflation was much lower—it can be a recipe for trouble today.
Remember: bonds are loans. If you invest in bonds when interest rates are low (and they really aren’t getting any lower than last year), you’re essentially giving back your hard-earned money in return. At the current rate of inflation, you could end up being repaid with dollars worth less than what you invested in the first place.
The amount of risk in your portfolio should be based on factors beside your age, including your retirement requirements, your desire to grow, or a combination of both. Your portfolio mix should be chosen carefully – and adjusted over time – to meet your individual needs.
The 4% rule
Another tricky old-fashioned formula is the “4% rule,” which suggests that you can safely withdraw 4% from your portfolio when you retire and continue to withdraw 4% per year from then on, taking inflation into account.
This rule of thumb has been around for decades and backtesting has shown that the concept made sense in the past. However, as interest rates are dramatically lower these days, it has been suggested that retirees could be more successful in making their money last longer if they lower their expectations to an initial withdrawal rate of 3%. And even then, the number you choose may need to be adjusted when the market is struggling.
Passive Investing Theory
If you can’t beat them, join them.
That’s the premise behind passive investing, which suggests that selecting individual stocks is an exercise in futility. Passive investing fans believe that since most investors will never be able to reliably “beat” the market, it makes more sense to invest in an index fund built to match or track it.
And they are not wrong.
Most active inventory managers can’t consistently beat the market over the long run, especially when you add in the extra cost of the work they do. Therefore, it can be smart to own a large share of the market (i.e. an index matched by a mutual fund) and cost efficient.
The problem is that this approach doesn’t necessarily apply to bonds — or real estate or other alternative investments like commodities — in the same way it does to stocks. Yet I rarely see a distinction between the different asset classes.
The theory also does not apply to all indices.
For example, if you buy an index fund that tracks the S&P 500, you match an index that always changes based on what all investors think the top 500 companies are worth. It is ‘market weighted’ and that seems logical to me.
But what about the Dow Jones Industrial Average? This index is listed a lot on the news, but it only lists 30 stocks – and the actual companies or stocks in this index have changed 55 times since the index was founded in 1896. Wouldn’t the index creator, in this case Dow Jones, be considered some sort of active manager?
The truth is, it doesn’t have to be an either-or argument. Many investors can benefit from combining both passive and active investment strategies. Mutual funds are easy to buy, easy to understand and offer broad market exposure. But there is nothing wrong with using part of your portfolio to actively prepare for or respond to changing market conditions or to further diversify your positions.
The key is flexibility.
The Bottom Line for Retirement Savers
Financial theories and rules of thumb are best used as general guidelines, not fixed rules. Many were meant to make planning easier — but if you treat them as mandated or force yourself into a formula that doesn’t meet your needs, risk tolerance, or goals, you’ll likely find yourself making it harder than it needs to be. And you might find that the promised path to success has thrown you off course instead.
Kim Franke-Folstad contributed to this article.
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