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Investing Rules of Thumb

People like to simplify. We like easy-to-follow guidelines and easy-to-implement instructions. That’s why rules of thumb are so popular. The two investing rules of thumb that I see quoted most frequently are to:

  1. Set your bond allocation (as a percentage of your portfolio) equal to your age, and
  2. Save and invest 10% of your income.

I really like the first one. I think it’s quite helpful. The second one, however, is a mess.

“Age in Bonds”

Why is the “age in bonds” rule helpful? Because asset allocation comes down to just two variables:

The rule accounts for one of those variables (holding period). So all you need to do is adjust the rule’s prescription based on your volatility tolerance. No problem.

“Invest 10% of Your Income”

In contrast, the question of how much of your income to invest each year involves many more variables than the question of asset allocation. Specifically, it depends upon:

  • The age at which you started investing,
  • The age at which you plan to retire,
  • Whether or not you plan to continue working part-time,
  • Whether or not you expect Social Security to pay out at the rate it’s currently promising,
  • Whether or not you’ll have any pension income,
  • Whether or not you’ll own your home, and
  • What you plan to do in retirement. (Do you plan to travel the world? Or mostly just hang out in your hometown with your grandkids?)

The “invest 10% of your income” rule doesn’t account for a single one of those variables! If you ask me, that’s a dangerous oversimplification.

When a Rule of Thumb Doesn’t Cut It

Sometimes there’s really no shortcut. Sometimes you actually have to do the math (or find an advisor or online calculator to do it for you).

That’s the case when determining how much you’ll need to invest each month. That’s the case when determining how much life insurance you need. That’s the case when determining whether you should form an S-corp or C-corp for your business.

You get the idea. When it comes to your finances, rules of thumb can be dangerous. Even if there is a rule that pertains to the question you’re seeking to answer, it’s best to learn the reasoning behind the rule so that you can decide for yourself whether or not you should follow it.

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  1. Rick Francis says

    I will grant that the age in bonds rule helps automatically adjust for the holding period, but it seems like an over simplification. Does a 20 year old really need 20% in bonds? Could a 70 year old reasonably expect a 70%+ bond portfolio to last 25 years? Finally, if I want to leave an estate to my children, how do I balance my age and theirs?

    -Rick Francis

    -Rick Francis

  2. I think you make a great point about following rules of thumb. It’s all about what the individual needs. I would think that it makes more sense to figure up how much income you will need each month in retirement or the future, and then work towards creating a portfolio that will provide that.

  3. I’m not a fan of either of those rules. If you are young and don’t have a lot of assets, the greatest influence on you’re account balance will not come from asset allocation; it will be from your own contributions. The “age-minus” allocations can also lead to a warped sense of risk and reward because of the inverse relationship of risk to actual dollars at risk. Investment policy should be driven by the need for risk, not tolerance for risk. Find me two 35-year-olds (that aren’t a couple) with the same account balances, savings rates, and life goals, and I’ll eat my words.

    Savings rates and investment policy are far and away the two biggest influencers, within our control, on the success of our own financial plans. They should not be standardized by rules of thumb.

    Lastly, I cannot pass up responding to Rob’s own criticism of “oversimplification” being dangerous. If you look up “oversimplification” in the dictionary, you might se an example that says: “Reduce your stock allocation when PE10 is above 14 and increase your stock allocation when PE10 is less than 14.” …therefore dangerous!

  4. I agree with you about the “save 10 percent” rule of thumb, Mike. It oversimplifies and is therefore dangerous.

    I disagree with you about the “age in bonds” rule of thumb. I think that one oversimplifies too and that that one is dangerous too. At low valuations, a retiree could go with a 70 percent stock allocation and not be taking on much risk. At high valuations, a 30-year-old could go with a 40 percent stock allocation and be taking on excessive risk. There is no way to know how much risk you are taking on when buying stocks without taking valuations into consideration and the rule of thumb ignores this factor.


  5. Mike,

    I strongly agree with you about the 10% rule. I don’t know if you noticed my comment on Get Rich Slowly about that issue, but that’s why I made the free retirement calculator I have on my website. I worked out a way to take most of the factors you point out into account, and I did a lot of work to create a calculator that would work for people in a variety of situations.

    I won’t link to it on here, but if you’d like me to I can. It’s easy enough to find in the article you linked to on Get Rich Slowly.

    As far as the bond allocation goes, I’ll have to agree with Rick. I personally think going with something like (120 – your age) for your stock allocation is a bit better. But I won’t even be following that guideline. I’ll keep my portfolio in 100% stocks until I’m 20-25 years from retirement. Then I’ll switch over to the (120 – your age) rule of thumb.

  6. Here’s the calculator Paul’s referring to:

    Paul: I’m curious, what are the assumptions used for the calculator? Nice job by the way. Very easy to use.

  7. If you look up “oversimplification” in the dictionary, you might se an example that says: “Reduce your stock allocation when PE10 is above 14 and increase your stock allocation when PE10 is less than 14.” …therefore dangerous!

    We’re in complete agreement re this point, Dylan.

    At a P/E10 level of 15, the most likely long-term return on stocks is 5.6 percent real. That’s an exciting return. There is obviously no need to lower your stock allocation just because we have gone a bit above fair value.

    My objection to the Passive Investing model is that it argues that investors never need to change their allocations in response to price changes. That’s an extremist viewpoint, in my assessment. At the top of the bubble, the most likely long-term return was a negative number. When the long-term return goes negative, an allocation adjustment is called for, in my view. And that’s so regardless of whether the investor is 25 or 65.


  8. Ok, Rob, but even if you change it to “way above” or “much less than” it’s still a grossly oversimplified concept and therefore, by your own words, dangerous.

    I’m not really interested in debating the merits of your idea, I just wanted to establish that it is as much an oversimplification as theses other rules of thumb. And in my opinion, it’s potentially much more dangerous.

  9. in my opinion, it’s potentially much more dangerous.

    I’m grateful to you for sharing your thoughts, Dylan. It would be a responsibility on my head that I do not want to carry if I were to put forward my views and if community members who have differing views were to fail to share them with others in the community. This way people get to hear both sides of the story.


  10. Mike,

    Thanks for including the link and for the compliments on the calculator.

    The calculator itself uses the data from hundreds of thousands of Monte Carlo simulations, so the real question is what are the assumptions of those simulations.

    1. Inflation will average about 3.5% in the future. (That’s just a little higher than the historical average.)
    2. You invest in a portfolio that’s allocated with (120 – your age)% in stocks. No changing for valuations. (Sorry, Rob.)
    3. You invest in a diversified portfolio similar to the ones recommended by my free Vanguard portfolio allocation calculator (published today).
    4. The future average return and standard deviation for these portfolios will be the same as the historical average return and standard deviation.

    Those are the main assumptions that you can’t really see in the calculator. The rest of the assumptions depend on what you stick in the calculator! 🙂

  11. P.S. I think you’ll like the Vanguard portfolio allocation calculator, too. I designed it so that it recommends the best portfolio using Vanguard funds depending on how much you have to invest.

    For example, if you have $1,000 to $3,000 it recommends the STAR fund because that’s all you could get.

    $3,000 up to various amounts (depending on your stock allocation) it recommends either a Target Retirement fund or a portfolio that builds up to the more complex small-cap and value tilted portfolio. (You can’t invest in it right away because of the fund minimums.)

    Finally, when you have enough to invest that you reach $100,000 in a fund, it recommends you use the Admiral shares instead of the Investor shares for lower expenses. (Note how the ticker symbols and fund #’s change as you increase the amount available to invest.)

    Anyway, I thought it was pretty slick and useful, and I thought you’d like those features.

  12. Paul,
    Thank you for your calculators. They just reinforced my own opinions.

    At nearly 47 years old I cannot for the life of me find a good reason to invest nearly half my retirement savings in something with as limited a growth as bonds. Security is one thing, fear of losing it all is another. I still have a good many years before retirement and even if I do someday decide to retire early I can always move more assets to the bond fund at that time.

  13. No problem, Jerry! I’m happy to help.

  14. I believe the rules of thumb have some merit for people who are indecisive or naive in their investment decisions. I know when I first started investing I had no guidelines whatsoever. As one becomes a better (more informed) investor, asset allocation will be from several sources, not just a rule of thumb.

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