Investing can be incredibly complicated, with hundreds of thousands of investment choices that can be combined in nearly infinite variations. The sheer number of options available—and the high stakes involved in getting decisions right—can make the process overwhelming. That is one reason why rules of thumb can be useful. They are a way of cutting through complexity and helping investors make decisions more quickly without getting bogged down in endless questions about “what if” or “what is next.” These heuristics, or mental shortcuts, can help investors focus on the most important steps to take without getting trapped in analysis paralysis.
Keep 100 (or 120) Minus Your Age in Stocks
For decades, investors have relied on this simple formula for basic asset allocation guidance. Using 100 as a starting point effectively means targeting a bond weighing equivalent to your age, with the remainder in stocks. This guideline is based on the notion that younger individuals can afford to take on more investment risk because of their longer time horizons. As investors get older, their time horizons shorten, making an increasing fixed-income allocation more prudent.
More recently, 120 has been showing up as a more common starting point, partly because average life expectancies have gradually increased. Before his death, Vanguard founder John Bogle advocated using 120 minus one’s age to determine equity allocations, explaining that the previous guideline came to fruition in an era of much higher bond yields. In one of his landmark articles, one expert recommended targeting equity exposure at 128 minus one’s age as part of a comprehensive strategy to support sustainable withdrawals.
Why it works: This rule has stood the test of time partly because it is simple and intuitive. There is a strong link between life expectancy and investment time horizon, since a portfolio only has to last long enough to sustain a person during his or her natural life (unless someone wants to set aside money for bequests after death). In practice, investors implementing this rule would start out with hefty equity allocations that gradually glide down as they get older. Linking portfolio allocations to age might lessen the temptation to engage in market-timing (making dramatic allocation shifts in response to market moves). It also indirectly reinforces portfolio rebalancing, as keeping allocation in line with an age-based target would require pruning back equities after significant gains or adding to them after market corrections.
Limitations: Now that bond yields are even lower, fixed-income allocations are likely to generate lower total returns than in the past. That argues in favor of increasing savings, decreasing planned spending, or increasing equity exposure to boost long-term returns.
In addition, the age-based guideline may not be optimal for investors who are either just starting out or approaching the end of life. A 25-year old investor with decades left until retirement does not necessarily need any fixed-income exposure as part of a core retirement portfolio, assuming she already has an emergency fund and is willing to take on the higher risk inherent in an all-equity portfolio. On the other end of the age spectrum, some experts have argued that while a lower equity allocation in the years leading up to and immediately following retirement can mitigate sequence-of-returns risk, older retirees might consider gradually increasing their equity exposure over time.
The verdict: Age-based guidelines are a reasonable starting point but might be on the conservative side overall.
Diversify Your Portfolio to Reduce Risk and Improve Returns
It is often said that diversification is the only free lunch in finance. This quote, usually attributed to Nobel Laureate Harry Markowitz, refers to the power of diversification to reduce risk without necessarily hurting returns.
Why it works: In many ways, diversification does have incredible power. Within an asset class, adding up to about 20 additional securities can dramatically reduce a portfolio’s overall risk profile. And adding asset classes with lower correlations is where the magic really happens. The lower the correlation, the bigger the reduction in volatility. It is one of the few cases where the whole can be more than the sum of the parts; a well-constructed portfolio can have better risk-adjusted returns than its component parts alone.
Limitations: The problem is that correlation coefficients shift over time, so what worked in the past will not necessarily work in the future. In addition, adding asset classes to reduce volatility can also drag down returns, sometimes over multiyear periods. International diversification, for example, might have seemed like a no-brainer for investors about 30 years ago, given that international-stock indexes had handily outperformed from 1982 through 1991 and also showed a low correlation with U.S. market benchmarks. But over the past 10 years, non-U.S. markets have generally underperformed, and international diversification has dragged down returns more often than not. Other popular diversifiers, such as commodities and precious metals, have also gone through prolonged slumps at times.
The verdict: Partially true, but greatly oversimplified. Diversification remains a sound strategy, but it is an insurance policy that has a cost and will not always pay off.
Use 4 Percent of Assets to Determine Portfolio Withdrawals in Retirement
Investors and financial advisors have long relied on Bill Bengen’s landmark research on sustainable withdrawal rates, which found that for a portfolio combining 50 percent stocks and 50 percent bonds, setting an initial withdrawal equal to 4 percent of the portfolio’s starting value and then adjusting each year’s withdrawal amount for inflation has historically never fully depleted portfolio’s value, even during some of the worst market periods since 1926.
Why it works: This is another rule of thumb that has stood the test of time because of its ability to cut through complexity and provide reassurance about one of the biggest fears for retirees: running out of money. It is also useful because it can be easily reverse-engineered to determine a required savings amount for retirement. A 4 percent spending guideline would dictate a starting portfolio equal to 25 times annual spending. If you know that you want to spend $50,000 per year in retirement, for example, you can multiply that amount by 25 to figure out that you will need a portfolio size of $1.25 million.
Limitations: The 4 percent rule assumes that inflation-adjusted withdrawals remain at the same level year in and year out during retirement, regardless of market performance or changes in spending needs. In practice, many retirees spend more in the early years of retirement on travel and other pursuits, then spend less as they age and more toward the end of life because of medical costs or long-term care. There has also been extensive research about more flexible approaches to withdrawals, such as setting guardrails based on portfolio size or market performance. In addition, there is some question about whether 4 percent will still be sustainable in an era of lower bond yields, which will likely weigh down returns for portfolios that include fixed income.
The verdict: The 4 percent rule is still a reasonable starting point, but investors may want to use a slightly lower number to account for potentially less robust long-term returns.
Most of the rules of thumb discussed above have stood the test of time. Understanding some of the nuances behind how they can—or can not—support a sound portfolio strategy can help investors apply them more effectively.
Nina Azwoir, First Vice President of Investments, Wintrust Wealth Management. © Morningstar 2020. All Rights Reserved. Used with permission. Securities, insurance products, financial planning, and investment management services offered through Wintrust Investments, LLC (Member FINRA/SIPC), founded in 1931. Trust and asset management services offered by The Chicago Trust Company, N.A. and Great Lakes Advisors, LLC, respectively. Investment products such as stocks, bonds, and mutual funds are: NOT FDIC INSURED | NOT BANK GUARANTEED | MAY LOSE VALUE | NOT A DEPOSIT | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY.