Retiree Portfolio Your Retirement Safety Cushion

Part of everyone's portfolio should be invested in short- to mid-term securities instead of stocks. By investing in such vehicles, we can better protect money we know we must take from savings within the next three to seven years from the severe market declines of the stock market. The trick is to decide how much money should be kept out of the stock market, and where to invest that sum.

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By David Braze (TMF Pixy)
July 9, 2001

"It's the economy, stupid!"

Remember that campaign slogan popularized during the 1992 presidential election? I do. I also remember that the candidate who employed those words won that race. Possibly his campaign's catchphrase had something to do with his victory. I really can't say. But does that matter? The words still endure, possibly because they embody some truth. So let's paraphrase them into a Foolish slogan for today:

"It's the stock market, Fool!"

To me, that one simple sentence says it all. On one hand, it highlights The Motley Fool's preference for stocks as the vehicle of choice for our long-term investments. We believe most strongly that stocks are where we will get the biggest bang for our buck over the long term.

On the other hand, that sentence also recognizes that stock values can and do move violently, both upward and downward, and often with breathtaking speed. A steep decline can be absolutely gut-wrenching. If you had to liquidate some investments to obtain needed funds, would you want to sell stocks during a period when stock prices are falling? Most of us would relish that prospect almost as much as we would enjoy getting a poke in the eye with a sharp stick.

About a year ago, I wrote about bear markets. I pointed out that as of that date we had experienced nine declines in the stock market of 20% or more in the last 50 years. On average, it took 31 months to go from the market's peak to its low and back to its former peak. But the actual periods to do so ranged anywhere from seven months to seven and a half years.

These bear-market statistics are why we believe that no money you will need within the next three to seven years should be invested in stocks. If you're an aggressive investor, then a three-year reserve should remain out of the stock market. If you're a conservative investor, then a seven-year cushion should suffice. I'm partial to a five-year period myself. Once I have a five-year cushion of all the income I will take from savings set aside, my remaining assets are invested in the stock market.

How do you determine how much money you should keep in your safety stash? Look at every short-term expense you know you will pay for from your savings (i.e., not from your job income, pension check, Social Security check, etc.). Then examine your willingness to take a risk in the stock market. You should assume you will keep at least three years' worth of needed savings out of the stock market, but your aversion to taking a risk could increase that amount. If you're retired, I gave some hints on how to establish the actual level of safety investments in my article Creating a Comfy Income Cushion. Those not yet retired may obtain some helpful clues from what I said in Step 2 of our new Short-Term Savings Center.

Whatever you do, avoid the tendency to make a big drill out of this calculation. Just anticipate what expenses you must pay from savings over the three- to seven-year period. The total of those expenses then becomes the amount you will invest in something other than stocks. And the only thing that really determines whether you will have a three-year or a seven-year level of safety is your ability to sleep soundly at night regardless of what the stock market does. The less you trust stocks, the more you will have in your safety stash.

Where should your comfy cushion go? Into things like money market funds, Treasury bills, I Bonds, certificates of deposit, and short- to mid-term bonds. That way you will still earn interest yet avoid most of the volatility found in the stock market.

Invest your safety cushion in anything that meets your comfort level. I like to put my current year's draw into a money market fund until it must be spent. That way, I continue to earn a small return on my funds. For a higher rate of return, I split another four years' income evenly between short-term and mid-term bonds. Some folks use a combination of Treasuries, certificates of deposit (CDs), and/or a bond ladder.

Assume I use a bond ladder for the remaining four years of my safety cushion. That means one-fourth of my bond portfolio would mature in each of the next four years. Whenever a particular one-fourth of that ladder matures, I could then either reinvest that one-fourth in a new bond issue at the going interest rate so it would mature four years later, or move it to something else like CDs or a money market fund.

Be aware that I could achieve the same effect as a bond ladder with arguably less market risk by using a CD ladder. CDs have a maturity period from as short as 90 days to as long as five years. Typically, CDs yield a smaller return than bonds, but they have FDIC insurance that may make them more attractive to many.

There are a number of ways you can handle your short-term investments to ensure they are not in stocks. The method I use is simply one that allows me to sleep comfortably at night. You should select a method that lets you do the same.

Want more ideas on where to put your safety cash? Check out Where to Stash Your Cash, an excellent primer written by my colleague, Robert Brokamp. Don't tell him it's excellent, though, or he'll get a swelled head and become even more insufferable than he already is.

So, there you have it, the basics of why to use and how to create a safety level of short-term income. It's definitely not rocket science, just common sense. Once built, the only maintenance required is to review your needs once each year to replenish or increase your safety stash as needed.

And remember -- "It's the stock market, Fool!"

See you next week. Comments? Then post away on the Retired Fools or the Retirement Investing boards.

Best to all... Pixy

Dave Braze enjoys his work. Why? Because he works for The Motley Fool, and The Motley Fool is all about investors writing for investors. Besides, the company actually pays him to have fun, and Dave thinks any entity silly enough to do that deserves his (ahem) labors.