8 Rules of Thumb for Saving and Retirement
Financial planning still requires some math Sometimes the best advice is the simplest. After all, if it wasn't short and sweet, "stop, drop and roll" probably wouldn't do much for someone on fire. In the same way, financial rules of thumb are useful to many Americans who can't or won't make time for complete and in-depth financial planning.
"Rules of thumb are generally useful for most households, because we found through our research that simplicity is good, (and) that complexity is really the enemy of good household financial decision-making," says Michael Finke, associate professor of personal financial planning at Texas Tech University in Lubbock, Texas.
But while they're useful as rough guidelines for day-to-day financial decisions on saving, investing and retirement, rules of thumb often oversimplify complex issues in ways that can harm long-term financial prospects, says Certified Financial Planner Steve Pomeranz, host of "On the Money" on National Public Radio affiliate WXEL-FM in Boynton Beach, Fla.
"In order for you to do it right, you've still got to do the math, and that's the problem with a rule of thumb. It prevents you from doing the necessary math," says Pomeranz.
How much house can you afford?
The rule: You shouldn't buy a house that costs more than 2 years' worth of your income.
Why it works: During the wild years of the housing boom, consumers seemed to stop grounding their housing decisions in income. This rule can help remind consumers that income should be a primary criterion when deciding how much to pay for a house.
Grain of salt: One problem with this rule is it doesn't take into account how housing costs can fluctuate based on interest rates, says Pomeranz. For instance, a house that costs 2 times your income may be unaffordable in a high-rate environment but easy to pull off in a low-rate environment, says Pomeranz.
A better guide to whether to buy a home is rental prices in your area, says Finke. If you could rent a home that meets your needs for less than it would cost to buy and maintain a home, then renting is a no-brainer, he says.
Stocks vs. bonds
The rule: The percentage of your portfolio invested in bonds should equal your age.
Why it works: Famously repeated by Vanguard founder John Bogle, this rule of thumb helps investors keep in mind that their portfolios need to change as they age, becoming more focused on avoiding risk in their investing than on higher growth. That's because older people have less time to recover from stock market shocks than younger people.
Grain of salt: As you enter retirement, taking all your money out of stocks could slow the growth of your portfolio too much, preventing you from keeping pace with inflation and possibly depleting your retirement savings, says Pomeranz.
The rule: To make sure your retirement lasts, never withdraw more than 4 percent a year.
Why it works: This simple formula has proven accurate over time, helping people easily figure out a guideline for how much they should withdraw so as not to exhaust their retirement savings, says Baughman.
Grain of salt: Be sure to track how your portfolio is doing. If it takes a hit, adjust your withdrawals downward. Withdrawing 4 percent of what your portfolio used to be worth is a good way to deplete it quickly, says Pomeranz.
Finke says another potential danger is that you won't live long enough to justify withdrawing only 4 percent of your savings, and that you'll miss out on taking vacations, making charitable contributions and giving gifts to family members. Finke says a better solution may be to use part of your retirement funds to buy an annuity or other insurance product to provide a base of lifelong income, allowing you to draw from your retirement funds more freely.
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