One of the worst things about getting older is that it seems like nobody wants you to have any fun. You have to be more careful about your health. When you exercise, you're supposed to keep your heart rate in a safe zone. Some retirees even face having their driver's licenses taken away once they reach a certain age.
It's much the same with investing. After spending a lifetime making investing decisions and gaining valuable experience in the stock market, you'll hear most financial planners tell you that you should take a more conservative approach with less stock exposure. They'll cite the risk of owning stocks and say it's too high once you get older.
Consider your own situation
For many people, that logic makes sense. When you're young, you have time on your side, with decades before you'll need whatever money you save for retirement. With all of that time ahead of you, you can afford to take some big risks -- and even if your investments don't do well at first, it won't be fatal to your long-term financial prospects. That makes high-growth stocks a viable option, even when their prices can fluctuate much more wildly than the overall stock market.
On the other hand, as you approach or enter retirement, you no longer have the luxury of a long time horizon to weather stock market downturns. You need that money now, and if the next market crash happens to hit you at just the wrong moment, 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 universally accepted that certain types of mutual funds do it automatically. Target retirement funds change their investment strategy gradually over time to accommodate your changing risk tolerance. Yet even though these funds make investing automatic, they aren't able to handle all of the specific needs that you may have.
Why one-size-fits-all might not fit you
Reducing stock exposure as you get older only addresses one risk that investors face: the potential for falling stock prices. But that's not the only risk people have to deal with as they move toward retirement. Inflation is a huge threat to your long-term prospects, even if your portfolio is big enough to cover your costs at the beginning of your retirement years.
Low interest rates have been a big thorn in retirees' sides lately. Even if you lock up a $1 million portfolio in 10-year Treasury bonds, you'll only earn about $27,500 at current rates in order to cover expenses each year. 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. Many well-known companies have histories of raising their dividend payouts annually for decades. When they push their dividends higher, it provides extra income that retirees can use to keep up with the impact of inflation. Moreover, that income can prevent you from having to sell shares at inopportune moments.
That said, some fortunate people have enough wealth that they can tolerate the risk of market downturns. For them, a typical retirement plan might involve selling some stocks every year to supplement other sources of retirement income.
You can protect against the risk of a market drop by keeping enough money in safer investments to give your stocks a chance to recover. Even though this strategy involves keeping several years' worth 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 2007 following this strategy, you might have chosen to forgo selling stocks in 2008 and 2009, waiting until the market recovered to sell and replenish your cash reserves.
Getting more conservative as you grow older is a basic rule of thumb, and it can be helpful for beginning investors to follow. The better choice, though, is to weigh the risks of different investment strategies and pick the one that will work best for you. That means you won't have to give up the fun of stock investing no matter how old you get.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.