At Sensible Financial, we are not big fans of financial rules of thumb. We are keen on the data at hand, as each situation is different. Rules of thumb may bear some truth and be directionally sound. However, they can be poor pieces of advice for many people. I will make the case that some investing rules of thumb are off base.
This will be Part 1, geared a bit more toward the accumulation phase of life, and Part 2 will be geared more toward the decumulation phase.
“The stock market always goes up over time” (i.e., long-term stock ownership is riskless)
This is the fallacy of time diversification, the widely held belief that stocks in the long run are much less risky than in the short term. Professor Zvi Bodie of Boston University says, “It leads to the illusion that one can earn an equity risk premium without bearing risk.” This is, of course, appealing. Who wouldn’t want higher expected returns without risk?
It’s true that we have been fortunate investors in American history. But no one knows if that will be the case in the future. Just look at the developed Japanese stock market, which only passed its 1989 high in 2024 (and still has not returned to that level on an inflation-adjusted basis). Too many advisors across the country believe that you ought to invest in stocks in order to retire. We at Sensible would argue the exact opposite. If your “retirement is in jeopardy,” you should not invest heavily (or at all) in stock.
In addition, young people often have the capacity to hold high percentages of stock. But it is not—as instinct might tell you—because “markets always go up over time.” It is because their future human capital (the present value of future earnings) dwarfs their current savings. Even if current savings are invested 100% in stock, their human capital, which is bond-like, makes for a much lower overall equity allocation.
“100 minus age” asset allocation
It’s ingrained in society that young people should have (or can have, at least) a high equity allocation, and those who are older should have a lower equity allocation. Essentially, one should de-risk as one ages and nears retirement. This is directionally accurate for many, but by no means applicable to all. Think of a recently retired couple whose Social Security and pension income cover their spending, or an 85-year-old affluent widow. They can afford much higher allocations to stock than the rule of thumb would advise. Similarly, think of a 30-year-old with few assets who wants to buy a home and start a family soon. He or she ought not to have a high stock allocation, because the dollars are needed to fund a goal. The rule of thumb fails to consider each couple’s unique circumstances.
“Put as much as possible into your 401(k) when young”
You may have heard this before or even said it to someone else. It is directionally true to advise young people to begin saving (and to do so in a tax-preferred way). However, putting as much as one can into a retirement account may very well lead to cash flow issues once one is hoping to buy a home and/or start a family. It is important to begin forming good savings habits and to contribute at least enough to receive an employer’s match. But it is equally important that they save in a liquid manner (bank and brokerage) to fund shorter-term goals such as home and/or family. For all intents and purposes, retirement account savings cannot be used to support one’s 20s, 30s, 40s, or 50s.
In Part 2 of this series, I’ll delve into the decumulation stage of investing and debunk more commonly shared rules of thumb.
Photo courtesy of Tima Miroshnichenko on Pexels