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:

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:

• Why you'll regret the set-and-forget approach to saving;
• Stocks that will help you retire happy; and
• How you can build a road map to wealth.