If you're a retiree (or near-retiree) wondering how to allocate your moola, you've generally got three main options: stocks, bonds, and cash. The theory is that when one market segment is down, another may be up, and vice versa. So, by dividing your money (not necessarily in equal parts) among all three segments, you shouldn't see all your money shrink at once. You'll have decreased your downside risk, while still maintaining some upside risk.
The "cash" category doesn't necessarily mean just cash -- especially cash stuffed into a cigar box under your bed. Instead, think of it as simply very liquid investments -- those that can be converted into cash quickly and easily. Many of these actually pay interest, too, such as money market accounts and short-term CDs.
How much money should you have in each category? Well, one age-old guideline recommended that you should subtract your age from 100 and devote that portion to stocks. Therefore, a 50-year-old would have 50% of his or her portfolio in stocks and a 70-year-old only 30%. As people started living longer, the number to subtract from became 110. This isn't a baseless approach, but it's wrong to assume that we're all alike in everything except age. This rule's results won't be right for everyone. It's best to take some time and assess your particular situation carefully, to determine the right allocation mix -- one that should generate the income and portfolio growth required for the rest of your life.
A helpful way to approach the problem is to jot down how much you have, how much you want to withdraw each year, how quickly you expect your nest egg to grow invested in your various options, and how long your money needs to last. The stock market, on average over the past few decades, has gained about 11% or so annually. Meanwhile, fairly conservative bonds have offered between 3% and 6% annually, while cash can actually lose value over time, because of inflation.
However you decide to divide your money, you'll need to reassess your allocation periodically. Let's say that you allocated 50% of your savings to stocks, 30% to bonds, and 20% to cash. If, after 12 months, you notice that your stocks have grown to become 55% to 60% of your portfolio, you might want to rebalance and reallocate a little.
A Foolish retirement allocation is really determined no differently than it is for any other investor at any other age. Figure out which mix fits your risk tolerance for losing money yet still achieves your objectives, which should be growth and income. Adjust for risk by controlling the ratio of stocks within that portfolio. A major factor in your decision making is your desired withdrawal rate from your portfolio.
Make sure you're tending to your big retirement picture. Begin planning now. We can help you reach your dreams with our Rule Your Retirement newsletter. It's issued each month, is readable in a single sitting, and contains lots of valuable tips, inspiration, and motivation. (One great feature in it is the frequent stories of people who explain how they retired early and well.)