There are many retirement rules of thumb that we are all familiar with. Rarely will anyone question the validity of universally accepted advice. But few generalized pieces of advice are bullet proof. Not every retirement technique is true and others are misinterpreted. Here are five often misunderstood retirement rules of thumb.
1. The 4 percent withdrawal rule. Everybody has heard of the 4 percent withdrawal rule. As long as you withdraw 4 percent from your retirement portfolio annually and adjust it for inflation, there's a very good chance that you will never run out of money.
The problem: While there’s a very good chance you won’t run out of money using this strategy it’s not guaranteed that you won’t. Let's say someone offered you a chance to never have to worry about money ever again. To determine the results, you are allowed to roll the dice once. If it lands on 1 though 5 you are given $10 million dollars. However, if it lands on 6, you and your family will be slaves to a very demanding boss for the rest of your life, guaranteeing a miserable life. Will you take the chance even though you know that the statistics are on your side?
2. Hold stocks for the long term. Stocks are volatile in the short run. We already know that. But many people think owning stocks over the long run decreases the risks involved.
The problem: Stock performance is particularly important during the last stretch of your career when you have the most assets and the least time to recover from any major crisis. During this time well performing stocks could significantly boost your ability to retire comfortably but a major downturn could wipe out a large portion of your savings. Stock performance in the years leading up to and immediately after you retire matters much more than the previous several decades.
3. Shift into conservative assets as you age. Older investors with higher account balances need to focus more on protecting their existing account balance than chasing returns.
The problem: This one I actually agree with because the older you are, the more stability you need. But many people have much more money invested in the stock market in their 60s than in their 30s. Imagine you are in your 30s with retirement accounts totaling $100,000 completely invested in equities. Not bad at all. You continue to save and accumulate $1 million dollars by age 65 and gradually scale back your risk to a 60 percent stocks and 40 percent bonds portfolio. But even with the more conservative asset allocation you now have $600,000 in stocks, compared to $100,000 in your 30s. Asset allocation is much more important in your twilight years. This is not just because you have less time to make it back. It's simply because the dollar amount is so much bigger.
4. Dollar cost averaging. Investing a small amount of money on a regular schedule over a long period of time allows you to purchase more shares when prices are low and fewer when prices are high.
The problem: Dollar cost averaging is good for your emotions, but not necessarily for your pocket book. While doubling down makes you feel better because the cost column seems to be lower, sometimes investing the whole lump sum will produce better results. You win with dollar cost averaging when the market goes down and then back up and you lose when the market keeps climbing higher. Sure, you will feel like a genius if you decided to dip your toes into the market instead of investing the lump sum in 2007, but the reverse is true when you had the same choice in March of 2009. Since no one can time the market and the general direction of the market is up, there's actually a better chance of getting higher results if you just invest the whole lump sum.
5. Planning for your retirement date. Many individuals have an investment strategy focused on accumulating enough to retire.
The problem: The big day when you call it quits is no doubt a significant event, but it's not the end of your investing journey. So many of us are told to base our time horizon on when we plan to retire, but the event is just one day in our lives. Our time horizon is not until the day we retire but perhaps 30 years past our retirement. For those who plan to leave money to heirs, the time horizon is even longer because it stretches past your lifetime and into your children's.
Many of these retirement rules of thumb may work for most of us. However, your retirement is personal and the consequences of faulty advice can be severe. Take a step back and reconsider the retirement advice you are following.
David Ning runs MoneyNing, a personal finance site aimed at helping others change their habits for a better financial future. He suggests that everyone to sign up for an online savings account to get more out of our hard earned money.