Some of the best-known rules of thumb in personal finance have lost their usefulness.
While it’s helpful to have a starting point for a housing budget or savings goal, or for allocating an investment portfolio between asset classes, many popular guidelines date back to a time when growth house prices and wages were more closely aligned, student debt had not crossed the trillion dollar mark, and stocks and bonds did not fall at the same time.
Here are four outdated rules and suggestions for more realistic ways to think about finances.
Housing: the 30% rule
The old rule states that rent should not eat up more than 30% of a household’s pre-tax monthly income.
This criterion has become unrealistic in much of the country as housing costs rise. The national median asking rent hit a record high of $2,032 in July, according to online broker Redfin, meaning you’d need to earn nearly $6,800 a month to meet the rule.
This was already proving impossible for many even before the pandemic-fueled rise in rents. Harvard’s Joint Center for Housing Studies found in 2019 that nearly half of renters spent more than 30% on rent and utilities. For 24% of them, the rent consumed more than half of their income.
“Housing can easily account for over 30% of our income, especially in expensive cities,” said financial planner Nicole Sullivan of Prism Planning Partners. “But spending much more than that can lead to enormous pressure. After all, you have to eat, pay taxes, cover medical expenses.
In general, Sullivan advises waiting for a cheaper place to come on the market, living with family or a roommate for a while, asking for a raise, or even looking for a new job.
Budgeting: 50/30/20
This rule suggests that about half of your income should be spent on “essential” monthly expenses like groceries, transportation, and housing. Thirty percent goes to “wants” and 20% goes to savings.
While this approach makes creating a budget less daunting, necessary expenses such as health insurance and student loan repayments consume more of the average person’s salary today. For low-income households, more than 50% can easily go towards housing, while allocating 30% to needs may be excessive for high-income households.
The rule also assumes that someone can start saving at a young age. If someone saved 20% in their early twenties, they would be fine in retirement. But start saving at age 45 and you’ll need to increase that percentage.
Financial planner Niv Persaud of Transition Planning and Guidance prefers the term “spending plan” to “budget.” She asks her clients to break down expenses into 10 broad categories, including housing, transportation, food, personal care, recreation and savings.
“These broad categories make it easier for customers to see where they can cut spending to afford something else,” she said. “Some will reduce spending on food, entertainment and personal care to offset an increase in housing expenses due to a new home.”
Investment: 60/40 Portfolio
A 60% to 40% split between stocks and bonds has long been considered a classic portfolio mix. The idea is that stocks provide growth and bonds provide some stability by zigzagging as stocks zag.
It hasn’t worked recently. Stocks and bonds are falling amid the highest inflation in 40 years and interest rate hikes by the Federal Reserve, with markets expecting another giant 75 basis point hike next week. A Bloomberg benchmark that tracks the performance of the 60/40 strategy posted its worst first half since 1988 and is down about 13% this year through Monday’s close.
A Bloomberg survey found that many professional and individual investors still rely on the 60/40 portfolio to beat long-term inflation, but financial planner Ben Offit of Offit Advisors thinks it’s an outdated concept.
Offit says clients only need to hedge against bear markets when they’re about to retire and dip into their portfolio. Keeping two to five years of spending on fixed income avoids having to sell stocks in a bear market. The rest of the portfolio is invested in stocks, and “it has nothing to do with a percentage,” he said.
Retirement: 4% withdrawal
How much can a retiree safely withdraw from their savings each year? The 4% rule – taken from a 1994 study based on a conservative low-fee portfolio – says that if a retiree withdraws 4% in their first year and adjusts that for inflation each year thereafter, their silver has a good chance of lasting 30 years. .
The rule may be particularly ill-suited to current retirees, who expect market returns to be below normal for an extended period and inflation to remain high. Some personal finance experts say it should look more like a 2.5% or 3% rule.
An alternative is “dynamic” withdrawals, where after a year of poor returns, retirees withdraw less so that a nest egg is not eroded too much by selling in a bear market; in a good year, they get more.
The Bottom Line: “Rules of thumb can be great starting points,” said Christine Benz, Morningstar’s chief personal finance officer. “But these are just that – starting points.” If someone wants to consider the 4% rule, that’s fine, she says, “but they should think about other dimensions of that: what is the composition of their portfolio, how do they actually expect to spend in retirement, etc.
To see how your budget, savings, debt and more stack up against seven key personal finance metrics, try Bloomberg’s interactive tool, WealthScore.
Bloomberg News provided this article. For more articles like this, please visit bloomberg.com.
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