Rule Your World

I’VE NEVER BEEN a fan of financial planning rules of thumb. To understand why, consider a common shortcut for choosing an asset allocation: The allocation to bonds in a portfolio, according to this rule of thumb, should equal an investor’s age.

For example, if an investor is 65 years old, his or her allocation to bonds should be 65%. That sounds reasonable—until you realize that Microsoft founder Bill Gates is 65. Should he have the same asset allocation as everyone else his age? Perhaps he’s an extreme example. But how about a 65-year-old who is retired with a secure government pension? As you can see, rules of thumb can quicky break down.

It’s for this reason that I’m skeptical of rules of thumb. But in a recent interview, behavioral scientist Sarah Newcomb cited the work of Gerd Gigerenzer. A professor and the author of Gut Feelings, Gigerenzer challenges the view that rules of thumb are a less-than-optimal way to make decisions. In some ways, he argues, they are superior to a strictly numbers-based, analytical approach.

To illustrate, Gigerenzer cites the collapse of the hedge fund firm Long-Term Capital Management. An entire book was written about it. But in short, what happened was that the fund’s managers relied too heavily on statistical models using historical data. They failed to consider the possibility that things might turn out differently—and worse—in the future than in the past. And that’s exactly what happened. In 1998, the fund suffered a spectacular failure, going to zero essentially overnight. Were it not for a bailout by the Federal Reserve, Long-Term Capital might have taken down its trading partners, including some of Wall Street’s biggest banks.

This was an extreme but hardly isolated case. It’s why Gigerenzer asserts that rules of thumb shouldn’t be dismissed as an inferior way to think about problems. On the contrary, Gigerenzer sees greater risk in trying to be overly analytical in situations that defy quantitative analysis. In the case of Long-Term Capital, the Nobel laureates who ran the fund were too brilliant for their own good. They were so wedded to their sophisticated math that it resulted in their undoing. If, instead, they had allowed more flexibility into their thinking—flexibility that wouldn’t necessarily have been supported by the numbers—they might have had more margin for error and might have survived.

I’m still wary of rules of thumb, but Gigerenzer makes a useful point. It’s good to be analytical where appropriate. But sometimes, employing a rule of thumb might be better. Below, for example, are five questions that might be better answered with a rule of thumb than a spreadsheet:

1. What’s a safe portfolio withdrawal rate in retirement? A few weeks ago, I talked about the famous 4% rule. I pointed out that even the rule’s inventor used a higher number—4.5%—and that today many prefer a lower number, closer to 3%. Ultimately, though, these numbers are all in the same ballpark. No one suggests, for example, that 10% is a safe withdrawal rate. For that reason, the 3% to 5% range is, in fact, a useful rule of thumb.

2. How much growth can we expect from the stock market? Historically, the U.S. stock market has returned 10% a year, on average. But population growth today is much slower than in the past. For that reason, many advisors—myself included—build plans around a lower number, in the 7% range. Is that based on a mathematical model? No, it’s simply a rule of thumb, but one that recognizes that it’s far worse to under-save for retirement than over-save.

3. What will future stock market downturns look like? On average, in past bear markets, stocks have dropped 27% and taken 32 months to get back to even. In building a financial plan, is it safe to rely on these long-term averages? In my opinion, no—because averages can be misleading. Between 2000 and 2002, the market fell 45% and took six years to recover. Between 2007 and 2009, the market fell 51% and took four-and-a-half years to recover.

That’s why the rule of thumb I use is to assume a market downturn could last seven years—more than twice the long-term average and longer than any downturn since the Great Depression. Again, this isn’t based on scientific analysis. Instead, it’s designed to avoid making the mistake Long-Term Capital made, which was to put too much faith in statistics. It also acknowledges that things were quite a bit worse in the Great Depression. Though that was nearly 100 years ago, it can’t be entirely ignored.

4. With all the negative headlines, will Social Security be there for tomorrow’s retirees? The last time Congress overhauled Social Security’s retirement benefits was in 1983. But the changes didn’t negatively affect anyone older than age 46 at that time. Most of the impact fell on people who were younger than 30. The changes were justified by rising life expectancies.

That’s why I think a reasonable rule of thumb is to expect that Congress will make changes again in the future, since life expectancies have increased since 1983. But I also think it’s safe to assume Congress will take the same approach as last time, placing more of the burden on younger people. If you’re mid-career, you might see a small decrease in benefits, but not enough to worry about. What if you’re later in your career? I wouldn’t worry much at all.

5. What should I assume in terms of life expectancy? If you want, you can consult actuarial tables online. But those are just averages. If you’re trying to build a retirement plan for yourself, a good rule of thumb is to assume you might make it to 100. There is, of course, no scientific basis for choosing 100 instead of 99 or 101 or any other age. But I think it’s far better than building a plan that’s tailored too tightly around your actuarial life expectancy, with no room for error. That again was the mistake made by Long-Term Capital.

How can you know when it’s best to pull out your calculator and when it’s okay to rely on a rule of thumb? Well, here’s my rule of thumb on that: The more information you have on a given question, the more I would lean toward quantitative analysis. Asset allocation, for example, lends itself to careful analysis, because it’s so personal and because so much of the relevant data is available. But if something is completely out of your hands—what the stock market will do, for example, or what Congress will do—then a rule of thumb may serve you better than trying to overanalyze to the point that you’re really just guessing.

A final note: Gerd Gigerenzer is a serious academic. But he also has a sense of humor. If you have 30 seconds, I recommend this old VW commercial. He’s the one on the right, with the banjo.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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