Rules of Thumb For The New Year

Jan 9, 2024 | Financial Planning, Investing, Investment Portfolios, Newsletter, Personal-Finance, Retirement Planning, Retirement savings

Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

Regular AAC (Asset Allocation Composite), SAA, and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Thursday, February 1, 2024. 

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Rules of Thumb For The New Year

Long-time readers know that we have consistently advocated simplicity in personal finance and retirement investments. Rules of thumb, acting as first-level guidelines, prove remarkably effective, even in their simplicity. This resonates with our overarching belief that simplicity is, indeed, better.

To kick off our newsletters in this new year, we are outlining several important and useful rules of thumb for savings and retirement investments.

The 80/20 Rule

The 80/20 rule stands out as one of the most crucial rules of thumb in engineering, product development, and even in our daily lives. It states that the initial 80% of progress is frequently achieved through 20% (relatively easy) effort. Subsequently, the remaining 20% of progress demands a more substantial 80% of effort. This principle is also somewhat connected to the concept of ‘low-hanging fruits.’

In our everyday experiences, consider the scenario where an individual who doesn’t engage in daily exercise begins incorporating even a modest amount of regular physical activity into their routine. Initially, there are discernible health benefits that become apparent. However, as time advances, achieving similar enhancements becomes increasingly challenging, even if the individual expends greater effort and dedicates more time to fitness activities. This underscores the notion that the initial gains from lifestyle changes are often more perceptible, and subsequent progress may necessitate a more concerted and sustained effort.

This gives rise to the following rules of thumb, which, despite requiring relatively minimal efforts (around 20% or even less), can yield substantial improvements (around 80%) in your financial situation or investments once consistently followed.

Savings & Personal Finance

Let’s begin with some rules of thumb in savings and personal finance. Some of them are related or even overlap. . 

50-30-20 budget rule

This budgeting rule states that you should allocate 

  1. 50% on needs such as bills, rent/mortgage, education, transportation, etc. 
  2. 30% on discretionary spending such as movies, eating out, vacations, etc. 
  3. 20% on savings and investments

Now is a good time to review your spending from the previous year and determine if there are areas of improvement to align with this rule.

15% to 20% savings rule

Building upon the aforementioned, it is frequently advised to allocate 15% to 20% (the 20% in the 50-30-20 rule) of your income each month or with every paycheck towards savings and investments. These funds are typically directed into both short-term savings and long-term investments, which may include avenues like a 401(k) or IRA account, as well as a brokerage investment account.

The 15% to 20% savings rule for retirement serves as a starting guideline to assist in building a substantial nest egg over the long term. The primary objective is to attain a reasonable retirement lifestyle, maintaining or even improving upon one’s current standard of living through consistent and early savings.

For those interested in exploring more different outcomes, our Retirement Calculator provides a useful tool for conducting various studies. 

It’s also important to regularly reassess and adjust contributions based on changing circumstances to ensure a more personalized and effective retirement savings strategy.

6X emergency spending fund

Aside from the above savings rules, it’s often suggested that one should put aside at least six (6) times your monthly income into an ultra short-term (cash) savings account. This reserve serves as a crucial emergency fund, intended to cover unexpected expenses like sudden medical bills or other unforeseen financial challenges. We have detailed several ways to enhance your cash returns.

For up-to-date and valuable cash savings recommendations and information, we highly recommend the Yield Alley website. This site provides timely insights into bank savings, broker CDs, Treasury bills, money market funds, and ‘money market’ ETFs, offering very detailed practical guidance specific to many brokerages and banks. In our opinion, Yield Alley is by far the most comprehensive and dedicated website dedicated to cash and income savings. 

40% debt rule

The recommendation not to spend more than 40% of your monthly income on mortgage or personal loan payments is a widely recognized guideline, often employed by lenders to assess the amount they can responsibly lend to an individual. Some lenders may use a slightly more lenient standard, such as 50%. For instance, if your monthly income is $10,000, the suggested maximum allocation for your mortgage or loan payment would be 40%, translating to $4,000 per month.

When coupled with the 50-30-20 rule, which allocates 50% of your income to needs, 30% to wants, and 20% to savings, it becomes evident that a 40% allocation to mortgage payments leaves only 10% for other essential expenses such as bills. This underscores the importance of looking at multiple rules for proper budgeting. 

Investment Rules of Thumb

Let’s move to guidelines/rules for investments. 

Rule of 72 — doubling rule

The Rule of 72 offers a quick way to estimate the duration required to double your investment. To derive the number of years necessary for this doubling effect, divide 72 by the annualized return percentage. It’s important to note that the annualized return should be used as a percentage, meaning the percentage symbol should be removed. For instance, if the annualized return is 10.7%, the appropriate calculation would be 72/10.7, not 72/0.107. 

Some typical numbers:

  • 7.2 years to double your money if your annualized return is 10%.
  • 3.6 years to double if the annualized return is 20%.
  • 4.8 years to double if the annualized return is 15%. 
  • 12 years to double if the annualized return is 6%. 

For a very long-term (20-year or longer) investment horizon, a reasonable estimate of annualized return ranges from 6% to 15%, you can use rule of 72 to quickly estimate how much your investment will become after a given number of years. 

80% of returns from asset allocation

It’s widely believed that 80% of investment returns are decided by asset allocation. This belief or rule is rooted in various studies that include the landmark work by Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, titled “Determinants of Portfolio Performance II: An Update” (1986). This study, often referred to as the Brinson study, examined the components influencing portfolio returns and found that asset allocation accounted for a substantial portion of the variance in performance.

Additionally, subsequent research, such as the study by Ibbotson and Kaplan (2000) titled “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?” further corroborates the idea that a significant proportion of investment outcomes can be attributed to asset allocation decisions.

The significance of this rule is that investors should foremost focus on asset allocation first, and funds or individual investments second. 

This rule could be viewed as a variation of 80/20 rule in investing!

100-age stock asset allocation

This straightforward rule suggests allocating a percentage equal to 100 minus one’s age to stocks in an investment portfolio. For instance, if you are 45 years old, the allocation to stocks would be 100 – 45 = 55%, with the remaining 45% allocated to bonds.

It’s important to note that this is a highly simplified rule, as individuals may possess various assets and potential sources of retirement income, such as pensions and Social Security. Consequently, this rule may result in an allocation that is either too conservative or too aggressive. Nevertheless, it can serve as a quick guideline for determining stock allocation, especially in specific accounts like a 401(k), providing a rough estimate.

25x asset rule

This rule stipulates that you should possess funds amounting to 25 times your estimated annual retirement expenses. For instance, if your anticipated or estimated annual living expenses during retirement amount to $100,000, according to this rule, you would require 25 times $100,000, equating to $2.5 million, to retire comfortably.

It’s worth noting that this rule is connected to the well-known 4% retirement withdrawal rule that states that to sustain ample funds throughout retirement, one should withdraw a maximum of 4% annually from their investment portfolios, adjusted for inflation. Interestingly, 1/4% is equivalent to 25! For 4% retirement withdrawal rule, see Maximizing Your Retirement Income: The 4% Withdrawal Rule & Retirement Withdrawal Calculator.

In summary, we strongly encourage you to acquaint yourself with these rules. Due to their simplicity, it becomes much more manageable for people to adopt or revisit them periodically. Based on our previous experiences, we have observed that many individuals find it challenging to consistently engage with intricate aspects of personal finance or investments. Given the demands of work and home life, it’s understandable that people often prefer not to add another substantial task to their responsibilities. These rules of thumb, with their straightforward nature, aim to mitigate any reluctance and provide a more accessible approach to financial planning.

Market Overview

The so-called Santa Claus rally, traditionally extending from year-end to the beginning of the year, encountered a sudden disruption last week, with significant losses observed in both stocks and bonds. However, they recovered most of their losses today. It remains to be seen whether such weakness will persist.

The economy appears to maintain a “Goldilocks” equilibrium. The latest employment report from last week indicates a robust labor market in December, with the unemployment rate holding steady at an exceptionally low 3.7%. Investors are contemplating whether this strength might lead to sustained high interest rates, potentially contributing to the stock market’s weakness observed last week. Investors are hopeful for lower interest rates while the economy sustains growth, aiming to avert a recession— the so-called “soft landing.” It again remains to be seen whether this scenario will materialize. It is thus interesting to closely monitor this week’s December CPI or inflation report scheduled for Thursday.

Stock valuations persist at elevated levels. Considering that last year’s gains in broad-based indexes, such as the S&P 500, were largely driven by a select few (the “magnificent 7,” including Apple, Microsoft, Amazon, Google, Tesla, Meta, and Nvidia), several possible scenarios may unfold. Option A involves a decline in the expensive subset represented by the magnificent 7, affecting the broader stock market—a downward scenario. Option B would be the rise of inexpensive stocks, with the expensive ones either declining or maintaining their positions, resulting in a flat or upward market trend. At the moment, it does look like the bullish trend continues. 

As always, we claim no crystal ball and we call for staying the course which is guided by the well defined and sound strategic and tactical strategies:

  • For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as we have emphasized numerous times when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years, preferably much longer, given the current high valuation. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later and preferably many more years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
  • For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially during this time. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This is true time and time again.

Stock valuation has dropped, and now valuation is becoming less hostile. However, it is still not cheap by historical standards. For the moment, we believe it’s prudent to be extra cautious. However, how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.

We again would like to emphasize that for any new investor and new money, the best way to step into this kind of market is through dollar cost average (DCA), i.e., invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

Struggling to Select Investments for Your 401(k), IRA, or Brokerage Accounts?

 

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