Maybe you have not been formally taught a lot about how to invest your savings. Having a simple set of rules is a great way to get you started off on the right path to good investing strategies, making the seemingly impossible easily possible.
Here are our top five.
1. Rule of 72
You don’t have to be a “mathie”, like me, to understand this rule. The Rule of 72 is an easy way to estimate how long it takes compounding interest to double your investment. How does it work?
The Rule states that if you divide 72 by the return or “yield” you are earning on an investment you see how long it takes for your investment to double. Let’s say you are earning 7% on your investment. 72% divided by 7 is a little over 10. So, it will take about 10 years to double your investment at this rate. Assuming the 7% is your net return after fees and taxes.
Perhaps you know you want to have $20,000 saved in 5 years for your wedding or a car. If you have $10,000 to lock in today, what yield do you have to earn to have that $20,000 in 5 years? The Rule says 72 divided by the yield must equal 5. This means 72 divided by 5 is the required yield. You will have to earn a little over 14% to reach your goal.
And then there is the Rule of 115 for those who want to know how long it takes to triple money. Let’s say you again can earn 7% on your investment. Dividing 115 by 7 is about 14 1/3 years. Can you wait that long? Notice it takes a little over 10 to double but only another extra 4 to triple. That reflects the power of compounding
2. “100 Minus Your Age” Rule
The old rule of thumb was to take your age and subtract it from 100. That is the percentage of your investment portfolio you were advised to hold in stock. Equities are riskier than bonds and cash so you earn a “risk premium” included in the higher return on equities as incentive to invest in them. The younger you are, the longer your investment horizon, the more equities you can hold to maximize your opportunities for return.
This rule has been around for so long that many have suggested it is dated. Given that we seem to have longer retirements and longer lives, some think that the 100 should be 110 or even 120. So, if you are 30, you might hold up to 90% equities using 120, and as low as 70% at the old 100. The important thing is to remember that this is just a rule of thumb that really supports taking less risk in your investments as you age. As you get older you simply have less time to make up any losses that you may experience due to stock volatility.
Another rule that I have heard of is that the percentage of bonds you hold should equal your age. I do not believe that it is a wise idea to totally eliminate stocks from your portfolio, but perhaps find solid company stocks that pay great dividends and protect you from inflation.
3. 4% Withdrawal Rule
In order to protect your principal when you start withdrawing from your investment portfolio during retirement this rule of thumbs suggests you withdraw 4% the first year and then in subsequent years, 4% plus a growth factor for inflation.
Let’s say at your first year of retirement you withdraw $50,000 out and inflation for the year is 3% then the second year you take out $50,000 + 3% ($1500) = $51,500. Every year after that you adjust the previous year’s withdrawal amount by the inflation rate.
This rule can work reasonably, but you must be mindful of what the portfolio is actually earning. If it encounters a significant loss, or lower than expected returns, you may have to adjust your withdrawals downward to avoid depleting your nest egg.
4. The Long-Term Inflation Average Is Around 3%, some use 4%.
Inflation erodes the purchasing power of money. What this means is that inflation works against your investments and your long-term financial goals. In order to be more certain that your investing strategy results in the achievement of your goals, you must factor in the effects of inflation on your return. You should know the real rate of return on your investments. If you earn 7%, with 3% inflation your real return is 4%. It seems that as you reach your later retirement years, over 75, spending tends to decrease which can offset the effects of inflation.
If you are lucky enough to earn a return equal to or greater than 4% plus inflation, following Rule #2 you will be able to preserve or actually increase your capital during retirement.
5. Very Few Investing Years Are “Average” – Invest for the Long Run
Over the long run the stock market returns an average of 10%. This return is not adjusted for inflation, so the real return is more like 6-7%. Stock prices are volatile in the short term so it is very unlikely that any given year’s return is likely to be 10%. In other words, average return is not normal return. The longer you hold equities, the more risk you eliminate from holding them – invest for the long run.
As with any “Rules of Thumb” there are always exceptions to the rule. Be mindful of your situation and adjust these rules accordingly.