February 24, 2017
I was recently watching a video of Dr. Andrew Lo at MIT and he was talking about getting dressed in the morning. I realize this sounds a little strange, so bear with me. If I go into my closet and I have 30 pairs of pants and 40 shirts, then deciding what to wear is a big decision because there are 1,200 combinations of shirts and pants (30 times 40). If I just spent five seconds thinking about each possible combination, it would take over an hour and a half to pick out my clothes for the day. And don't forget that I have to pick out socks and shoes as well! However, this is not how we make decisions. We have shortcuts that we take, which researchers call heuristics. We use tons of little tricks daily to make complex decisions and our lives easier. One of the things we focus on at Carroll Financial is making complex financial issues easier to understand. We like to keep things simple. Simple things are easy to remember and they stick with us. Unfortunately, in finance there are a lot of simple rules that frankly don’t work. Here are three simple financial rules you may have heard and why they are wrong or limiting.
“Save 10% of your income.”
This rule sounds really good and it’s definitely easy to remember. However, current research suggests that young people should be saving 15% just for retirement. If you are also saving for a house, car, education or something else, the number should be a lot higher. You might come close if you save 10% of your gross (before tax) income, but it is a pretty poor rule of thumb.
“Take 100 minus your age and that is the percentage you should have invested in equities.”
Easy to remember? Sure, but this is a gross oversimplification. Research definitively shows that this will reduce your lifetime income compared to a stable moderate allocation in retirement. This rule of thumb also ignores the unique circumstances of a person’s situation. How do they think about risk? What do they want to do with the money left behind after they pass away? How much income do they need? At best this rule is a gross oversimplification.