Why You Should Avoid 'Rule of Thumb' Investing

Why You Should Avoid 'Rule of Thumb' Investing

Doc's note: There's one popular rule many average investors follow in the hopes of keeping their portfolio growing.

But, in today's issue, originally published in Altimetry Daily Authority, Joel Litman explains that there are exceptions to the rule...

Investing is not a "set it and forget it" hobby...

It requires fine-tuning based on your specific goals, like whether you're saving for retirement or planning to buy a house in the next few years.

To meet your investing goals, you may need to rebalance your portfolio every now and then. Many financial advisers will say something similar... then proceed to offer the exact same advice to everyone.

For instance, it's common advice that your portfolio should be split between stocks and bonds based on your age...

You subtract your age from 100, and the remainder is the percentage of your money that belongs in stocks. So if you're 60 years old, 40% of your portfolio would go into stocks and 60% would go into bonds. That means your stock portfolio will continue to shrink over time.

There's a bit of wisdom in that strategy. Stocks are more volatile... So if you're going to need the money soon, you should have less cash in stocks.

However, that's where the good advice ends. As we'll explain today, you shouldn't build your investment portfolio based solely on any old rule of thumb...

It doesn't take much to underperform the stock market...

According to data from Wells Fargo Advisors, investing in the S&P 500 Index has returned 8% per year over the past 30 years.

If you had missed the 10 best stock market days over that period, your annual return would fall to 5.3%.

If you missed the 30 best stock market days, you'd only earn 1.8% per year (which wouldn't even keep up with the average inflation rate of the past 30 years).

And if you missed the 50 best trading days, you'd have lost money in the stock market.

Now, the data also shows that the best days in the S&P 500 were typically during a bear market or a recession. Meanwhile, the worst days tended to be in the midst of a bull market.

So not only is it expensive to not be in the stock market over the long term... it's also expensive to try to time the market.

Many folks who follow a rule of thumb like "100 minus your age" end up breaking their investing plan at the exact wrong time. They think they're being risk-averse as they sell some of their equity investments... and buy bonds when the stock market starts falling.

That's a recipe to miss out on some of the best trading days. These plans don't factor in any sort of macro outlook.

It also misses the bigger point about how folks should invest... not based on your age, but on your goals. In other words, it's not about how old you are.

It's about when you'll need the money.

Over the past 100 years, only one asset class has beaten inflation in every 20-year period...

We're talking about stocks, of course.

Bonds usually beat inflation by a bit... and cash always loses out to inflation. So regardless of how old you are, if you don't need your money for several decades, it should be in stocks.

This is the philosophy we put into our Timetable Investor framework each month... We summarize macro market signals and explain how they can help position investors for the next three to 24 months.

Rather than focusing on age, we encourage folks to think about their needs over time. To do that, we recommend everyone create four "buckets" of money.

First, you have money you'll need in the next two years. That should always be in cash, not the market.

There's no other asset that's guaranteed to keep its value over such a short period of time. Even bonds sometimes take more than two years to recover when they fall.

Next, there's the money you need between two and five years out. That should be in bonds and other income investments. Again, this is enough time for bonds to almost always recover... but not so for stocks.

Then there's the money you'll need between five and 10 years out. This should be a split between stocks and bonds. We typically recommend you put about 50% into each, though that can vary depending on how the economy looks.

The last bucket is for money you won't touch for at least a decade...

And those funds need to be in stocks.

This is the only way to keep up with the broader market. It might seem "safe" to be heavily allocated to cash and bonds. But it's a false form of safety... and an expensive one.

Any investor worth their salt will consider risk as part of their strategy. That said, you also have to consider opportunity cost. There's no one allocation split that works for every person.

Make sure your portfolio is set up to work for you. It's the best way to protect your money... and position yourself for long-term gains.

Regards,

Joel Litman

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