Here are 4 simple investment formulas that could revolutionize your investing. Well, maybe that’s pushing it a little, but if you don’t know them they can certainly help you simply the investing process, and that’s important.
No matter where you look these days, people are always trying to complicate things and this is never more true than in the investment field, but it doesn’t really need to be that way.
In fact, with most investors will be served perfectly well by simply investing in global stocks and some of their home country’s government bonds, via a couple of index funds.
The only questions we really need to be asking are what percentage of stocks compared to bonds? How much you should withdraw from your pension pot? What returns you can expect? And how much you are actually going to need in retirement?
And the great news is that each one of these questions can be answered by simple investment formulas.
I like to call them the 4% rule A, B, C and D (because they are all based on 4%)!
Use A for working out what percentage of your portfolio should be invested in stocks compared to bonds. Use B to determine how much of your nest egg you can safely withdraw per year. Use C to estimate your investment returns and use D for calculating how much money you’ll need in retirement.
You’ll notice I used the word rule and not formula. That’s because they are more ‘rules of thumb,’ than formulas per se, but at the end of the day formulas are just rules expressed in symbols anyway, so without further ado here’s 4 simple investment formulas that might just revolutionize your investing:
The 4% Rule A
You can use this rule A to determine what percentage of your portfolio should be invested in stocks, when compared to bonds.
Just multiply the number of years you are going to invest by 4% and hey presto!
So if you were investing for 20 years you’d have 80% of your portfolio in stocks, but if you were only investing for 2 years, you’d limit stocks to 8%.
Number of years to invest X 4% = percentage of stocks you should have in your portfolio
The 4% Rule B
For most people the process of investing is pretty straight forward, and can be divided into three parts. The first is saving money. The second part involves investing that money so that it grows at a quicker rate and the final piece of the puzzle is spending.
In the beginning people often forget about the spending bit, but at some point you are going to reach a point where you need to start dipping into those savings……..usually retirement.
The question then becomes how much can I safely withdraw without running out of money?
Luckily some very clever people have done some very clever research and number crunching and come up with the answer: 4%.
That is to say, if you limit your withdrawal to 4% per year, you shouldn’t run out of money.
Total investment balance X 4% = Amount you can safely withdraw per year without running out of money
The 4% Rule C
Depending on their investing experience, people can have very different ideas about what returns we should expect from our investments. Some people think you should be able to make a fortune. The name Buffett comes to mind! But others think it’s more likely that you’ll loose a fortune. A few of my crypto currency trading mates come to mind!
But for investors that go globally diversified with their stocks there are some pretty smart people out there that think they know the answer. And you guessed it….. it is 4%! The chaps in question actually say 3.5% but I’m rounding up to single digits for the purposes of this one and it should also be noted that not too long ago they used to say 4.3% so I don’t think we are too far off with 4%.
(Note: That number is adjusted for inflation so if inflation was 3% the actual return would be 7% for example).
Average annual return for globally diversified stocks over the long term = 4%
The 4% Rule D
Use this simple investment formula to determine how much money you are going to need in retirement.
Just estimate how much money you are going spend in a year and multiply that value by 25. (If you don’t know how much you’ll need in retirement you can assume 80% of what you need now).
So if you decide you need £40,000 a year to live off, you simply multiply 40,000 by 25 to get the amount of money you are going to need in retirement i.e. £1,000,000.
Some might be shocked by the fact you need so much money to provide you with that level of annual income and thinking about it, they’d be right to be, because it certainly seems like a lot of money.
But don’t forget, you may have other income such as your state pension or existing property that should reduce your requirements (You can read more about this here and if after reading that you still don’t feel confident you’ll have enough for retirement, it may be worth considering retiring somewhere where your money will go further which you can read more about here . {Warning: both articles are based on burgernomics!})
More observant readers may have noticed the fact that unlike the others, this rule is based on 25 rather than 4, and to be fair, they’d be right. However, the reason I’ve still named it a 4% rule is because in reality it is actually based on the 4% rule B above. Let me demonstrate:
Based on our example above we’ve decided we need £40,000 a year to live off. This means we need £1,000,000 in our pension pot (25 x £40,000).
And you may remember with the rule for working out how much you can withdraw from your final balance (the 4% Rule B) you just multiply the balance by 4%. 4% of £1,000,000 is £40,000.
( £1,000,000 * 4% = £40,000).
Amount of money you need in retirement = the money you spend in one year X 25
Tweaking these simple investment formulas
For the tinkerers out there, each of these simple investment formulas could be tweaked either up or down to take account of your risk tolerance. If your are brave and know something the rest of us don’t you might like to work with a greater number, but if you are a sensible type you might decide to tweak the number down a little just in case.
My personal take on this, would be not to tweak the number up i.e. above 4, but taking a more cautious approach via tweaking the number down to say 3% would be a perfectly reasonable thing to do.
And if you did that you’d just replace 4% with 3%: Multiply the number of years you are investing for by 3% to ascertain the percentage of stocks in your portfolio; Take 3% as your safe withdrawal rate; assume 3% above inflation for expected returns; and to figure out how much you are going to need in retirement you multiply by 33 rather than 25. (This 33 is approximate, but should give you a good enough figure to work with).
Who’d have thought the number 4 (or 3 if you are on the conservative side) could make things so simple?