"Rules of Thumb" are dumbing down the financial planning profession. What may be the correct advice for one person could be totally wrong for another.
Rule of Dumb 1: You need an emergency fund of 3-6 months of expenses
This is what most financial pundits in the media say everyone should have for emergencies. Well, that is a great goal but for most of middle-America that is simply a pipe dream. In financial planning we must be honest and realistic with our clients. Cash reserve amounts should be based on the needs of the individual not some formula.
Example: Someone who is self employed may need 6-9 months of expenses so they are not living out of their cash register in the event of an emergency. On the other hand, a 59 year old nearing retirement that has accumulated plenty of other accessible assets may only need a couple months worth of cash.
Rule of Dumb 2: You need 8-10 times your income in life insurance
This one just infuriates me. The rationale behind this is that if you died, your heirs could take that money invest it at a 10% return and the interest would replace your income. If your advisor believes that consistent 10% returns are that easy to come by and is willing to bet on it with the financial future of your surviving spouse, you should fire him or her ASAP. Then run far, far away!
So how did the pundits form this crazy opinion? Well, they look at the average lifetime return of the stock market and see that it has an average annual return of about 10%. Then they some how think that anyone can earn that average return easily year in and year out by buying "good growth stock mutual funds." It just doesn't work that way!
Example: Lets say your husband earns $50,000 per year and he died in 2007 with a $500,000 life insurance policy (10 times his income) and you following this advice expect a 10% return so you can live off the interest. Lets see how it really could really play out:
Year S & P Return Principal Balance + Gain - $50k withdrawal
2007 +3.5% $467,500
2008 -38% $239,850
2009 +24% $247,414
2010 +13% $229,577
2011 +10% $202,535
2012 +10% $172,789
2013 +10% $122,790
In this example, the money you thought would provide for you for your lifetime runs out pretty quickly if you follow the "Rule of Thumb". The market's history has an average of 10% but that in no way means that it is likely you will earn that each year. Heck, the S & P Index for the last 10 years has only earned about 3%.
If you are investing money for income you have to invest it in a way that gives you the best chance to meet your income needs while minimizing the risk of running out of money. If a widow needs my help to ensure she doesn't run out of money, I will not be basing my advice on a "Rule of Thumb" that ensures failure.