As you get older, it seems that no one wants you to have any fun. You have to be more careful about your health. When you exercise, you're supposed to make sure your heart rate doesn't get too high. Some folks even want to take away your driver's license once you get to a certain age.
With investing, seniors face the same challenge. After a lifetime of investing experience, and after you've gotten familiar with dozens of companies that have served you well, you may well hear financial planners telling you that you should bid farewell to those trusty stocks. They argue that the risk of holding those stocks is too great now that you're older.
One size fits all?
Sure, there's something to that logic. After all, when you're young, you have decades before you'll need the money you set aside for retirement. With all of that time ahead of you, you can afford to take some big risks. Even if your investments do badly at first, you can wait for them to turn back up again. Your timeline and risk profile would accommodate stocks such as Advanced Micro Devices (NYSE: AMD ) and Napster (Nasdaq: NAPS ) , for instance. Although these are volatile stocks -- each has a beta above 3 -- analysts are expecting fast growth. AMD and Napster are expected to grow at 15% per year for the next five years, making them suitable for investors with a longer time horizon and a stomach for volatility along the way.
Conversely, as you approach or enter retirement, you no longer have the luxury to weather long downturns in stocks. You need that money now for your living expenses, so if you're unlucky enough to get hit by the next market crash, you may have to sell at very low prices just to pay your bills.
The concept that you should reduce your allocation to stocks is so engrained in common wisdom that certain mutual funds do it automatically. So-called target retirement funds, which are featured in this month's new issue of Motley Fool Rule Your Retirement, are designed to change their investment strategy gradually over time to accommodate your changing risk tolerance. Yet even though these funds make investing very simple, they aren't able to handle all of the specific needs that you may have.
The problem with reducing stock exposure as you get older is that the potential for falling stock prices isn't the only risk that people face as they move toward retirement. Even if your portfolio is adequate to cover your costs when you're just about to retire, the threat of inflation is ever-present in retirees' minds.
With a $1 million portfolio invested entirely in ultra-safe Treasury bills, you can earn about $50,000 to cover expenses each year. But even if that's enough right now, your portfolio value will remain locked at that $1 million mark, and it won't be long before rising costs eat away the purchasing power of your fixed income. Stocks, on the other hand, offer not only prices that rise over time but also rising dividends. Companies such as Johnson & Johnson (NYSE: JNJ ) , General Electric (NYSE: GE ) , and ExxonMobil (NYSE: XOM ) have a long history of increasing their dividends regularly, providing extra income that can help seniors keep up with inflation -- even when the stocks themselves have suffered temporary drops.
On the other hand, if you've saved up a substantial nest egg for your retirement, you may be able to tolerate the risk of market downturns. For instance, a typical plan for a retiree might have you sell some of your stocks every year to supplement your retirement income.
However, you can hedge the risk of a market drop by keeping enough money in safer securities to give your stocks a chance to recover. Even though this strategy involves keeping several years of expenses in bonds, CDs, or cash, it still gives you the ability to keep a substantial fraction of your portfolio in assets that will provide you a better return. As an example, if you had retired in 2000 following this strategy, you might have chosen to forgo selling stocks in 2001 and 2002, waiting until the market recovered to sell and replenish your cash reserves.
Rules of thumb are helpful for beginning investors. To get the best results, however, you have to know when to break those rules. By weighing the risks of different investment strategies, you can pick the one that will work best for you. And you won't have to give up the fun of stock investing no matter how old you get.
The May issue of Rule Your Retirement releases at 4 p.m. ET today. You can see the new issue, with more analysis of target retirement funds as well as coverage of income-producing annuities, with a 30-day free trial. There's no obligation to subscribe, and a trial gives you an all-access pass to the service, back issues, calculators, and discussion boards.
Fool contributor Dan Caplinger isn't growing old gracefully, and don't expect him to give up his car anytime soon. He doesn't own shares of the companies discussed in this article. Johnson & Johnson is an Income Investor recommendation. The Fool's disclosure policy is appropriate at any age.