One of the most important ideas in personal finance comes not from a finance expert but from a twentieth century English philosopher named Carveth Read. “It is better to be vaguely right,” he wrote, “than exactly wrong.”
Why is this idea important? It gets at the heart of why financial planning can be so tricky. For starters, few people—if any—can claim to be perfectly rational when it comes to money decisions. But more to the point, even if we wanted to be perfectly rational, the reality is it wouldn’t even be possible. Why? As financial planner Ashby Daniels has written, “All data is, by definition, about the past, but all decisions are, by definition, about the future.” In other words, in the absence of a crystal ball, there really is no such thing as being truly rational when making financial decisions.
That’s why Read’s prescription is so valuable: Instead of trying to be precisely right—an impossible goal—we should instead aim to be roughly right, to be in the ballpark. This probably seems intuitive, but what does it mean in practice? Here are nine ways in which investors can apply Read’s recommendation to be roughly right:
1. How to ensure you have enough. If you’re in your working years, you may be wondering how much to save for retirement. Or if you’re in retirement, you may wonder how much you can safely spend each year. To answer these questions, you could build a spreadsheet. But any spreadsheet will be lacking in one key way: There are just too many variables. First, and most obvious, our spending goals might change. Other unknowns are inflation, taxes and market returns. The solution? I suggest starting with a spreadsheet—but not just one. Explore multiple scenarios. You can’t address every eventuality, but if you conduct a handful of stress tests, it’ll allow you to identify a range of reasonable answers. You’ll be roughly right.
2. How much to save in 529 accounts. These accounts are a special case because the money can only be used—without penalty—for education. Because of that, the key challenge is to avoid saving either too much or too little. How can you be roughly right? Instead of choosing the five-year front loading option, the approach I recommend is to make regular annual contributions. That will allow you to assess the growth of your account each year. And it’ll allow you to gain a better sense of your children’s educational needs. Do you see them headed to a state university, for example? Or do you see them going to a private college and maybe graduate school? There’s a wide gap between those two ends of the spectrum, and when children are young, it’s too difficult to know where they’ll end up. Stage your contributions out over time, though, and it’ll be easier to be roughly right.
3. When to stop contributing to tax-deferred retirement accounts. Conventional wisdom states that folks in their working years should take every opportunity to defer income into their 401(k). But there does come a point for some people when they’ve accumulated too much in tax-deferred accounts. How could this be possible? Required minimum distributions from tax-deferred accounts can push some investors’ income up to surprisingly high levels in their later years, resulting in surprisingly high tax rates. This might seem improbable, but business owners and professionals with access to multiple tax-deferred accounts can find themselves in this situation. I’ve seen folks in their 80s stuck in the top tax bracket. Because of that, it can make sense at a certain point to shift future savings away from tax-deferred accounts. When? Again, I’d start with a spreadsheet. But if the numbers could go either way, one solution would be to split your contributions evenly. As I’ve noted before, there’s nothing wrong with a split-the-difference solution when there is no clear answer.
4. How much to hold in cash. This is a source of concern for many. On the one hand, no one wants to risk a cash crunch. But on the other, no one likes to see assets lying fallow. The solution? Total up all of the possible things that might go wrong—a new roof and a new car at the same time, for example. Since there’s no reason to think multiple bad-luck events would all occur at the same time, this number would represent the absolute maximum you might hold in cash. Then adjust up or down from there, but with this number as a guide, you’ll have a better chance of being roughly right.
5. How to balance a portfolio. In personal finance, people debate endlessly about how to structure portfolios. Does it make sense to include international stocks? If so, how much? And on the bond side, does it make sense to buy corporate or even high-yield bonds? It’s impossible to know in advance which portfolio will be best. And you don’t want to rely on talking heads. Fortunately, there is good quantitative research on this, from Vanguard and others, offering asset allocation ranges that can help you be roughly right.
6. How much to help adult children. Warren Buffett has often commented that his goal was to give his children enough so they could do anything, but not so much that they could do nothing. Even if you’re not Warren Buffett, you may struggle with this question. One sensible approach is to make incremental, annual gifts to your children. Smaller gifts are better than one large inheritance for two reasons: First, incremental gifts give you the opportunity to see your children enjoy the gifts. Second, it gives you the opportunity to see how they manage smaller amounts before giving them more.
7. Whether to employ dollar-cost averaging. Historically, the U.S. stock market has risen in about 75% of annual periods. That means that, statistically, dollar-cost averaging is illogical. But the alternative, lump-sum investing, has a problem of its own: If the market drops quickly after investing a big lump sum, investors may feel substantial regret. To square this circle, don’t view it as an either-or decision. If you have some money to invest, you might invest half right away then dollar-cost average with the rest. A formula like this might help you to be roughly right.
8. How to reduce a concentrated holding. If you work for a public company, its stock may account for an uncomfortably large portion of your portfolio. But reducing it might entail an outsized tax burden. How can you be roughly right? One way is to set a target for reducing the shares to a specific percentage of your portfolio—say, 10%. Then sell enough shares each month—regardless of where the stock price is—to reach that target over three or five years. Over that period, you’ll capture some good prices and some not-so-good prices, but overall, you’ll be roughly right.
9. How to allocate a windfall. Everyone’s heard about professional athletes who’ve earned millions only to end up in bankruptcy. The fact is, windfalls are tricky even if you aren’t a professional athlete. What to do? I suggest developing a framework. You might save 50%, set aside 30% for taxes and give 10% to charity. Of course, that’s only 90%. For the remaining 10%, intentionally do something you wouldn’t ordinarily do. It’s okay to head to the Mercedes dealership or the jewelry store as long as you’ve allocated just a fixed percentage. The key is just to strike a reasonable balance.