Recs

3

You Need to Protect Your Money

To earn the best returns, it pays to take risks. But that doesn't mean you have to take big risks with your money until the day you die.

Chances are you've heard stories about financial advisors who told their clients to pile into risky investments -- with disastrous results. Yesterday, though, longtime Fool Selena Maranjian wrote about the opposite problem: advisors who recommend taking too little risk.

It's certainly true that in putting together an investment plan, your neighborhood broker might be too conservative. But the suggestion that traditional asset allocation doesn't work for investors might mislead you into missing out on a very useful tool for protecting your portfolio from unnecessary risk.

You won't live forever
Yesterday's column cited a formula that shows that if retirees want to withdraw 4% annually, they need to earn at least 10% on their investments to keep up with taxes and inflation. That's true -- if you never want to spend a dime of your principal. Using the same assumptions as the column, at the end of 30 years, you'd have nearly three times what you started out with. After inflation, your nest egg would have just as much purchasing power as you have today.

Yet while your children and grandchildren would certainly thank you for leaving them a sizable inheritance, the risk you take on to earn a 10% return is substantial. Being 100% invested in stocks leaves you fully exposed to market downturns at a time you can least afford to handle them. In contrast, the traditional 60/40 split between stocks and bonds may reduce return, but it also protects your money against downdrafts in stocks.

Using historical returns of 10% for stocks and 5% for bonds, you can expect to earn about 8% on a portfolio with a 60/40 asset allocation. Although 8% may not keep up with inflation and taxes, it will give you a long glide path in spending down your retirement nest egg, potentially supporting withdrawals for as long as 40 years or more.

When to take risk
Where I do agree that investors should be more aggressive is in their working years. Although asset allocation still plays a role, it's more useful in dividing your money among different types of stocks and other high-returning assets. Consider this example from our Rule Your Retirement newsletter:

Asset Class

20-Year Annualized Return

Sample Stocks

Large-Cap Stocks

11.7%

ExxonMobil (NYSE: XOM  ) , Microsoft (Nasdaq: MSFT  )

Small-Cap Stocks

11.5%

Priceline.com (Nasdaq: PCLN  ) , Reliance Steel (NYSE: RS  )

International Stocks

10.7%

Vodafone (NYSE: VOD  ) , BHP Billiton (NYSE: BHP  )

Real Estate

12.4%

Public Storage (NYSE: PSA  )

Source: Rule Your Retirement.

These returns are all fairly close together, so you might think it doesn't make much difference which one you pick. But surprisingly, by allocating your assets among all four funds, you would have earned a return of more than 12% -- without any guesswork.

Why is it better to take on risk before you retire? It has to do with cash flow. While you're working, your paycheck covers living expenses, leaving your investments to grow unhindered. Because you're not making regular withdrawals, you can afford to take more of a risk.

In fact, by earning outsized returns throughout your career, you'll be in a better position to take less risk after you retire. With a huge nest egg, you won't have to gamble with your portfolio.

Making the right choice
Investors have different amounts of risk tolerance. General rules of thumb, such as striving to earn 10% returns, may be helpful as a starting point. But it's important to remember that each investor's situation is different. As you build your savings, your actual returns will help determine the best way to go forward -- and asset allocation will play a crucial role in earning the best returns while reducing risk.

For more on managing your retirement money, read about:

To learn more about finding the right asset allocation, take a look at the latest issue of Rule Your Retirement. Our team of expert analysts guides you through the decision-making process with several recommended portfolios that match up with different risk tolerances. A free 30-day guest pass gives you all the access you need with no obligation.

Fool contributor Dan Caplinger stopped guessing with his core portfolio a long time ago. He doesn't own shares of the companies mentioned in this article. Microsoft is an Inside Value pick. Priceline.com is a Stock Advisor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy protects you.


Read/Post Comments (0) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 662691, ~/Articles/ArticleHandler.aspx, 9/1/2014 8:37:59 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

Today's Market

updated 2 days ago Sponsored by:
DOW 17,098.45 18.88 0.11%
S&P 500 2,003.37 6.63 0.33%
NASD 4,580.27 0.00 0.00%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

8/29/2014 4:05 PM
BHP $68.63 Up +0.40 +0.59%
BHP Billiton Limit… CAPS Rating: ***
MSFT $45.43 Up +0.55 +1.23%
Microsoft CAPS Rating: ***
PCLN $1244.31 Down -6.40 -0.51%
Priceline Group CAPS Rating: ***
PSA $175.18 Up +1.33 +0.77%
Public Storage CAPS Rating: **
RS $69.92 Up +0.12 +0.17%
Reliance Steel & A… CAPS Rating: *****
VOD $34.34 Down -0.07 -0.20%
Vodafone CAPS Rating: ****
XOM $99.46 Down -0.11 -0.11%
ExxonMobil Corp CAPS Rating: ****

Advertisement