Yesterday, I wrote about "tax-smart asset allocation," the process of sorting one's investments by the amount of tax liability they generate and trying to hold the worst offenders in your tax-advantaged retirement accounts. After that article was published, a couple of readers wrote with questions about regular old asset allocation -- specifically, how much of a retirement portfolio should be in stocks as one gets close to retirement?

It's a good question, and one that gets a lot of different answers. I've heard of investment advisors pushing 45-year-old clients to keep half of their portfolios in short-term investments. I've also heard of 68-year-old investors trying to make up for lost time by plowing their nest eggs into biotech stocks. I wouldn't recommend either of those approaches for anyone, but as I see it, the "right" answer is this:

You should always own some stocks even if you're retired, any money you won't need for five or six years should probably be in the stock market, and you can manage the risk of your stock investments with asset allocation.

Sounds kind of aggressive, doesn't it? Actually, I think it's the low-risk approach. Here's why.

The case for stocks
I think you should always own some stocks -- as much as you can stand, even in retirement. On average, over time, stocks have historically gained about 10.5% a year, far outpacing bonds -- and the average inflation rate. Even once you're retired, keeping your longer-term investments in stocks is the key to making sure your nest egg stays ahead of inflation. Note the "longer-term" part -- I typically say five or six years because, historically, that has been enough time for the market to recover from all but the very worst corrections and bear periods. So even if the market takes a big hit, your stock investments should have plenty of time to recover. Your shorter-term money should be in bonds and cash.

Asset allocation, defined
"Asset allocation" is a term with a few different definitions. At the most basic level, it usually refers to allocating your assets (get it?) among different asset classes, often defined as stocks, bonds, real estate, cash, Van Goghs, and so forth. The idea is that those different categories go in and out of favor at different times -- bonds are often lagging when stocks and Van Goghs are soaring, for instance -- and that by spreading your money around, you can catch more of the ups while being shielded from some of the downs.

But asset allocation is also a useful strategy within an asset class. Just as, say, rising interest rates can simultaneously drive stocks down and make a money market fund more appealing, shifting market conditions tend to favor different kinds of stocks at different times. Let's look at some of your options.

  • Small caps. Over very long periods, small-cap stocks have led the market. And while over shorter periods they have tended to shoot up and then lag larger-cap stocks for a while, they're an essential part of any stock portfolio. If you're trying to reduce shorter-term risk, limit your small-cap exposure, diversify among industries, and stick with the cream of the crop.

  • Large caps. More stable as a category than smaller-cap stocks, large caps often do especially well during the later portions of bull markets, when investor confidence in small-cap stories tends to lag. No matter where the market is, though, you can't go wrong by including big-name stocks such as Coca-Cola (NYSE:KO) and Johnson & Johnson (NYSE:JNJ) in your retirement portfolio. Not only are they great bets to show solid growth over time, but their steady dividend payments can also provide an added boost (if reinvested) or a nice income stream once you're retired.

  • International stocks. Take advantage of global growth stories while diversifying your risk away from U.S. market conditions. If you're new to international investing, consider starting out with a global mutual fund.

  • REITs. Often left out of asset-allocation discussions, real estate investment trusts tend to move up and down at different times than other stocks (thus enhancing diversification) and can pay substantial yields. For an easy, diversified entry into this market, consider ETFs that invest in an international basket of REITs, such as the SPDR Dow Jones Wilshire International Real Estate Fund (AMEX:RWX) and WisdomTree International Real Estate Fund (AMEX:DRW).

Consider investments from each of these categories, and you'll be better prepared to weather the market's ups and downs. 

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Fool contributor John Rosevear has no position in the stocks named in this article. Johnson & Johnson is an Income Investor recommendation. Coca-Cola is an Inside Value pick. The Motley Fool has a disclosure policy.