Top 10 Investing Rules of Thumb

by on May 3, 2009 | Updated December 4, 2012 | ETFs Mentioned:

Not too long ago, J.D. over at Get Rich Slowly posted 25 Useful Financial Rules of Thumb. These guidelines are designed to help everyday people do more with their finances. We wanted to expand on that idea and make a more investing-specific list, with useful  rules of thumb for the everyday, buy-and-hold ETF/index fund investor. Here are 10 investing rules of thumb that can help you make the most of your long-term ETF portfolio [for further reading also Download 101 ETF Lessons Every Financial Advisor Should Learn]:

1. Rule of 72. The Rule of 72 states that you can divide the number 72 by whatever yield you are getting to see how long it would take for your investment to double. Master Your Card has a great example of how the Rule of 72 works in real life:

The membership share he currently has his money in is earning 1% interest. I explain the rule of 72 to him and then write it down on paper so that he can see what I’m doing…I like to draw crazy pictures when I talk numbers. So, I break it down for him. At 1%, it would take 72 years for his $165,000 to double. If he wen back to the money market — our rate up a little — he’d be earning 4.75% on his money and that would only take about 15 years to double. Clearly he’d have more fun in the next 15 years than he would in 72.

The concept works that same with returns on an ETF. You can estimate how long it will take for the money in your ETF to double if you leave it there at its average yield. Of course, because ETFs can change, it is probably best to figure this number on a five or ten year average (or a longer average if you can find one).

2. “120 Minus Your Age” Rule. The old rule of thumb was to take your age and subtract it from 100. That is your percentage of stock allocation. No Debt Plan, however, points out that with the new life expectancies, that rule is rather conservative. Instead, the suggestion is to change that 100 to 120:

As an individual investor, you need incentive to take risk. That incentive with stocks is — over the long run — higher returns. If you couldn’t earn higher returns in stocks then everyone would invest in safe assets like bonds, CDs,  and saving accounts. There would be no incentive to take the additional risk.

With longer retirements and longer lives, a little more risk at a younger age is needed to make sure that your money will last as long as you do. You can have some or all of your equity allocation in the form of ETFs (or index funds) comprised of stocks. Then, use a bond ETF like BND, or even a TIPS ETF (to protect against inflation),to account for your bond allocation. Note that in our ETFdb sample portfolio we actually recommend using the formula 110 minus your age, but the truth is, any of these rules will achieve the goal of moving to less risky investments as your investment horizon decreases. [For more ETF analysis, make sure to sign up for our free ETF newsletter or try a free seven day trial to ETFdb Pro]

3. The Long Term Inflation Average Is 4%.For the immediate future, deflation is one of the major concerns afflicting the economy. However, over time, inflation provides a real hit to your investment portfolio. AllBusiness points this out about assuming an inflation rate of 4%:

An inflation rate of 4% might not seem significant until you consider the long-term effect on your purchases and your investmentsFor example, in 20 years, 4% inflation annually would drive the value of a dollar down to $0.44.

Inflation also works against your investments. When pursuing long-term financial goals, from college savings for your loved ones to your own retirement, it’s important to consider the real rate of return, which is determined by figuring in the effects of inflation. When figuring the real rate of return on your investments, using a 4% annual inflation rate can help you plan more realistically for your future needs. Long-term, buy-and-hold investors know that they need to look at the big picture and add inflation-beating investments to their portfolios. When combined with rule #2, you can set up a long-term investment portfolio that has an asset allocation to that provides a capital preservation base but also offers growth that beats the rate of inflation.

4. Very Few Years Are “Average”. One of the indexes that is routinely touted as a great market beating investment is the S&P 500 (you can “buy” the S&P with an ETF such as SPY or RSP). Indeed, rolling returns from the S&P 500 show an historically high level on an average basis. However, the nature of the stock market is to move up and down; year-to-year consistency is not to be expected. Indeed, columnist Humberto Cruz points out that the S&P rarely makes it’s historical average in any given year:

The average historical long-term return for the S&P 500 Index is about 10 percent a year. But the index rarely comes close to returning 10 percent any particular year.

In the past 40 years, returns have ranged from a gain of 37.5 percent in 1995 to last year’s 37 percent loss. Only twice — gains of 10 percent in 1993 and 11 percent in 2004 — did gains range between 8 and 14 percent. Another thing to keep in mind that inflation must be subtracted from returns as well, so annual S&P gains on a real basis are closer to the 6-7% range.

5. You Need 20x Your Gross Annual Income to Retire. This rule is a great starting point for your retirement planning, though as GRS’s J.D. points out, this 20x your income rule may not be the be-all-and-end-all:

Another approach to retirement savings says that you’ll need to save about 20x your gross annual income to retire. In other words, if you earn $50,000 per year, you’ll need $1,000,000 to retire. Again, I think this is lame because it focuses on income and not expenses, and expenses are what matter. But still, this can be a handy gauge.

The point, of course, is that expenses may matter more. So use the 20x your income rule as a good starting point, but modify according to your expenses. Figure out how long you think your retirement will be and multiply that by your annual expenses. I think my retirement is likely to last 30 years. 30x my annual expenses of $40,000 (which will go down when I retire and no longer have a mortgage and student loans) is $1.2 million. Will my rule #2 asset allocation help me get there in 20 years when I retire? I can use rule #1 to get an idea. And, of course, I’ll still be adding to my retirement portfolio. Of course, this formula doesn’t take into account me living longer — or needing long-term care.

6. 4% Withdrawal Rule. In order to protect your principal during when you start withdrawing from your investment portfolio, use the 4% rule to figure out how much you can take out. Four Pillars offers an excellent explanation of how the 4% rule works:

The way the 4% rule works is that you start by taking 4% out of your portfolio in the first year – this includes dividends, interest, withdrawals. The next year you take out the same figure you took out the first year plus inflation. So if you start by taking $40,000 out and then inflation is 3% then the second year you take out $40,000 + 3% ($1200) = $41,200. Every year after that you adjust the previous year’s withdrawal amount by the inflation rate.

Of course, you will probably need to adjust this rule, depending on how your retirement is going, and how well the market is performing. But it’s a reasonable rule that can help you determine how much you can take out. And if your investments are beating inflation (a TIPS ETF can help ensure that some of your portfolio is at least keeping pace), this rule should last you quite some time.

7. Retirement Plan Priorities: 401(k) ’til match, then Roth IRA, then 401(k) ’til max. It’s a good idea to understand your retirement account investing priorities. There is a definite strategy that can be employed when you are putting money into your retirement accounts. The Motley Fool offers some great advice on retirement account priorities

Your priority should usually be your employer’s 401(k) plan, if it matches your donations to any degree. Take maximum advantage of matching funds, because they represent free money which will grow for you over time. The Roth IRA is the next best option for most people, since it offers a place where your (post-tax) dollars can grow tax-free for many years.

Note that you’re probably best off contributing as much to your 401(k) as you need to for the maximum match, then putting your next dollars into a Roth IRA. Once you’ve maxed out the Roth, look at the 401(k) again, and after that, a traditional IRA.

8. Save and Invest 10% of Your Pre-Tax Income. Before spending your money, follow the old adage “pay yourself first.” This is great advice! Take 10% of your income (pre-tax if possible) and set it aside, preferably in some sort of account that offers returns, such as a retirement account. Master Your Card offers this observation about the 10% savings rule:

Think about it this way: for every 10 dollars you earn, save at least one dollar for yourself before spending the rest. This practice is often referred to as “Paying yourself first”, implying that you’re paying to build equity in yourself with every paycheck. This money which you’re saving is then kept as a private reserve, which you can invest in a wide array of low-risk investment vehicles. Thus, over time you are building wealth not only through your regular deposits of 10% of your income, but also through the interest being earned on the money you’ve already made.

One of the best ways to do this is via direct deposit. Have a portion of your paycheck direct deposited into a savings account. Even better, make sure your retirement account deposits are coming out of your paycheck automatically as well. The best policy is to make savings automatic.

9. 10, 5, 3 Rule. This is a handy rule that states that you can expect a nominal return of 10% from equities, 5% return from bonds and 3% return on highly liquid cash and cash-like accounts. Of course, this is a an average return over the long haul. Here is what FIRE Finance points out about what is more likely to be the case this year:

Being conservative in nature and observing the current state of the market we’d rather root for a more achievable 8, 5, 3. That’s our rule of thumb for investing this year. Let’s see how the year unfolds as we go along and the lessons involved.

And it is worth noting that some feel as though equities offer lower average returns that 10%. The bottom line is that investment returns fluctuate year-to-year. It is also worth noting that ETFs can be used in many of these investments–including stock ETFs and bond ETFs. There are even cash and currency ETFs, such as FXE.

10. Required Return. There is an interesting formula to help you figure out your required return (this is a bit more advanced than our other rules, but it’s a useful one). It looks as follows: Required return = risk free rate + beta (historical market return – risk free rate). Allan Baraza offers this explanation of what each of the parts to this equation represent:

The risk free rate is the return on a 5 or 10 year government note. Choice of notes to use will depend on time horizon used to estimate the historical market return.
Beta is a measure of a stock’s volatility; the higher the beta, the higher the volatility. This volatility is relative to the market volatility. A stock with a beta of 1.5 means that the stock will rise 15% with a 10% rise in the market; conversely, it falls 15% with a market fall of 10%. It follows, then, that the market beta is 1.
Historical market return is a regression estimation of the return over the estimation time period.

He points out that during times of uncertainty and volatility, lower beta stocks are preferred. You can learn a little more about the advantages and disadvantages of beta in a useful Investopedia article on the subject.

These ten investing rules of thumb should serve you well in building and maintaining your ETF portfolio. Of course, there’s more to personal finance than just investing, so if you’re not yet to the point where you find this article to be helpful, you’ll want to check out GetRichSlowly’s 25 Useful Financial Rules of Thumb first.

[For more ETF analysis, make sure to sign up for our free ETF newsletter or try a free seven day trial to ETFdb Pro]