When it comes to structuring your investment portfolio, there's no single ideal model portfolio. Your best asset allocation will depend, in part, on your investment goals and how much time you have to build wealth. Here's how to create a solid retirement portfolio in five steps.
Shed risky stocks
One recipe for endangering your financial future is having an investment portfolio full of risky stocks. Even if you only hold a few risky stocks, you might want to sell them. Volatility is easier to handle when you're a long way from retirement: Should one or more such holdings plunge, you'll have time to wait for rebounding prices, and if a holding simply goes down in flames, you'll still be working and able to keep adding money to your investment portfolio.
There are plenty of stocks that are too risky for us at any time. These include stocks where you don't really understand how the company makes its money, where you don't see sustainable competitive advantages, or where the stock is simply overvalued.
Hold dividend stocks
So what kinds of stocks should you hold? Well, income-producing ones will be particularly welcome in retirement. Dividend payers are among your best options, but it's important to be selective. Look for healthy and growing companies (i.e. ones with little or no debt), competitive advantages (such as a strong brand and barriers to entry for would-be competitors, and plenty of room to grow), and focus on the dividend growth rate as much as the dividend.
A 2% dividend might be preferable to a 3% or even 4% one if it's being increased at a much faster clip. In a few years, it could be paying you more than the now-higher dividend. Look for relatively low payout ratios, too, such as those around 75% or lower. The payout ratio shows you what percentage of earnings are being paid out in dividends, and a high number leaves the company with little wiggle room and a greater chance of having to reduce its payout one day.
Preferred stocks, which tend to offer greater-than-average dividends and lower-than-average price appreciation, can also be good for retirees as they can generate significant income. You might build your retirement portfolio with one or more preferred-stock funds for diversification across a number of issues. The PowerShares Preferred Portfolio (PGX) exchange-traded fund (ETF), for example, recently yielded about 5.5%.
Real estate investment trusts (REITs), which hold real estate properties in categories such as commercial buildings, apartments, retail properties, hospitals, and so on, are another good bet in any kind of model portfolio, as they offer exposure to the real estate industry without requiring you to spend a lot of money on a physical property that you'll have to rent and maintain and that can be hard to sell sometimes. There are ETFs that focus on REITs, too, such as the Schwab US REIT ETF (SCHH).
Have a sensible asset allocation
The best retirement portfolios will have a sensible asset allocation, meaning that their assets will be distributed in an effective way across categories such as stocks, bonds, and cash. In general, the younger you are, the greater percentage of your assets should be in the stock market, as that's likely to grow faster than most alternatives. As you age, it makes sense to shift some assets into bonds, which tend to grow more slowly, but can offer a little more stability and diversification. It's also smart to have some cash on hand for emergencies, or to be able to quickly take advantage of opportunities, such as a great stock that temporarily plunges in price, or a downturn in the entire market.
A model portfolio for retirees will have a chunk of its assets in bonds (with the specific percentage depending, in part, on your risk tolerance), but it shouldn't avoid stocks. Even if you're 70 and have been retired for five years, you may still live to 90, meaning that some of your portfolio has many more years to grow.
You can aim to build your nest egg by including some growth stocks in your investment portfolio, too. Don't go too crazy with unproven companies, but it's reasonable to look at big, established companies that are still growing briskly, have competitive advantages, and have more room to grow. Consider, for example, companies such as Apple, Google, Amazon.com, Starbucks, and Celgene. Only buy in when their shares seem undervalued to you -- and understand that you will need to keep up with their developments lest you not notice when their fortunes change.
A model retirement portfolio will also hold slower growing blue chip stocks, such as Johnson & Johnson, General Motors, and General Electric. Again, wait for attractive entry points before building a position in any of them. And note that many of them will also be significant dividend payers, generating income for you.
Consider buying annuities
One of the best things you can do as you age is take more pressure off yourself financially -- and a great way to do that is via annuities. If you build an annuity or two into your retirement portfolio, you can receive dependable income without having to keep track of any investments.
Focus on fixed annuities, not variable or indexed ones, as they can be more problematic, with high fees and restrictive terms. A fixed annuity offers a fixed income (possibly increasing with inflation, if you pay for that feature), that can start arriving immediately or in the future. As an example, with a $200,000 investment, a 70-year-old couple might be able to collect close to $1,000 per month in fixed annuity income for as long as at least one of them is alive. A 65-year-old man could spend $100,000 today for a deferred annuity that pays him about $1,200 per month beginning at age 75. Deferred annuities can help you not run out of money as you burn through your nest egg in retirement.
Leave a margin of safety
Finally, consider building a margin of safety in your retirement portfolio. The steps above include some of that. For example, shedding risky stocks keeps your portfolio safer, and including a cash position in your asset allocation gives you more flexibility, too. One way or another, almost all of us need access to emergency money in case costly repairs, or a health setback, or some other pressing financial need rears its head. (The folks at Fidelity Investments recently estimated that a 65-year-old retired couple will spend a total of $260,000, on average, in out-of-pocket healthcare expenses.)
As you invest in stocks, if you only buy them when they seem undervalued to you, you'll be including a margin of safety. Buying an annuity or two (ideally from different highly rated insurers, in order to spread out the small risk of default), can also make your retirement portfolio safer by turning some of it into nearly guaranteed income.
As you plan your retirement portfolio and its asset allocation, keep in mind that life will occasionally throw curve balls at you, so you need to be ready for them.