When planning for retirement, there are four basic sources of uncertainty...
You don't know how long you'll live.
You don't know what the inflation rate will be down the road.
You don't know what investment returns you'll earn. (Expect 8% to 9% a year over the long term.)
You don't know whether the next year will be a bull market or a bear market.
In the best scenario, you would have a bull market in the year you retire so your portfolio would grow even if
you take withdrawals.
Unfortunately, if you get a bear market right away (as happened to those unlucky people who retired last
year), you can suffer a double whammy. The value of your portfolio falls. And, if you have to start withdrawing
money, it falls some more.
EXPECT TO LIVE A LONG LIFE
Develop a portfolio that can accommodate these four uncertainties and still provide you with enough cash to
live on.
Actuarial tables say that those who reach age 65 can expect to live to age 85 -- but remember, that statistic is
just an average. Today, many people will live to age 95 or older. If you're in decent health, it's smart to plan for
30 to 35 years beyond age 65.
Implication: Simply putting everything into bonds and trying to live off the income is no longer an option.
You could also see your style of living devastated by inflation. Even at 3% annual inflation, the value of a dollar
would be cut in half in 23 years.
Bottom line: With a 30-year time horizon, you must have stocks or stock funds in your portfolio.
Good news: With such a long time horizon, those who have not yet retired have plenty of time to ride out big
market declines. There's no need to worry about what the stock market will do next week, next month or even
next year.
FINDING A WAY TO SIT TIGHT
For retirees, it's a question of finding some way to sit tight with your portfolio through market drops. You need
a balanced portfolio of stocks and conservative fixed-income investments... probably 50% to 60% in stocks
and the rest mostly in money market mutual funds and short-term bonds.
The question is how to manage that mix to get the growth from stocks and yet also ensure having cash
available during a bear market.
Strategy: Keep at least three years' worth of living expenses in money market funds and short-term bonds.
This should enable you to ride out most market declines without having to sell stocks prematurely.
Stocks. As investors near retirement, they should gradually phase out individual stock holdings and switch
into no-load mutual funds.
Never keep more than 5% of your stock portfolio in any one stock. As we have seen recently, even such giants
as Procter & Gamble and Xerox can falter.
Mutual funds. If you already hold mutual funds, review them with an eye toward selling.
Most of us have accumulated a grab bag of investments over the years.
Look up each fund's holdings. That's the only way to assure that you have genuine diversification, not
duplication.
I see no reason to pay for actively managed funds. Few outperform the market averages.
I'm a great fan of index funds. I often advocate investing in broad stock market index funds, such as Vanguard
Total Stock Market Index Fund (VTSMX) or Vanguard 500 Index Fund (VFINX).
For greater flexibility, break down your index investments into different market sectors.
If you need cash: You can selectively sell only funds that have been performing well, leaving the others to
recover.
A basic index fund portfolio includes...
A large-cap growth index fund.
A large-cap value index fund.
A small-cap growth index fund.
A small-cap value index fund.
A real estate investment trust (REIT) index fund.
A foreign stock index fund.
For one-stop shopping, you can't do much better than the Vanguard family of index funds.
Emerging alternative: Investors can put together their own index portfolios of exchange-traded funds (ETFs).
Sponsored by big asset management firms, such as State Street Global Advisors, Barclays Global Investors
(www.ishares.com) and Merrill Lynch, ETFs are trusts that track different indexes, including the Dow Jones
Industrial Average (DIA or "Diamonds"), the Standard & Poor's 500 (SPDRs or "Spiders") or the NASDAQ 100
(QQQ or "Cubes").
These funds trade like ordinary stocks on the American Stock Exchange. That means you must pay brokers'
fees to buy and sell them, but you can trade them at any time during the day, not just at closing, as with
mutual funds.
ETFs provide diversity on a cost-effective basis. Expense ratios are often below the average for stock index
funds.
Trap: If you trade them actively -- which I don't recommend -- brokers' fees can significantly reduce your
returns. For smaller amounts and monthly investments, mutual funds make better sense.
FIXED-INCOME CHOICES
For those who would feel more comfortable knowing a check will be coming every month, consider putting up
to 25% of your fixed-income portfolio into an immediate fixed annuity.
An insurance industry product, the fixed annuity is best suited to those age 70 or older and in good health.
Because you give the insurance company a lump-sum payment, you can lose if you die soon. You can,
however, pay to guarantee payment for, say, 10 years. Another problem is that your checks won't increase to
cover inflation.
To find companies offering good yields, check www.annuity.com... www.annuityscout.com... and
www.annuityshopper.com. Choose only a highly rated insurance company.
Treasury Inflation Protection Securities (TIPS) constitute another sleep-well fixed-income investment.
Ten-year TIPS currently yield about 3 ½% interest, which includes a semiannual adjustment to principal for
inflation, based on the rise in the consumer price index.
You can buy TIPS directly from the government at www.publicdebt.treas.gov.
Investing Strategies That Let You Sleep at Night
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