The stock market can certainly take investors on a wild ride. With the market's potential for huge up-and-down swings, retirees are often leery about keeping their money in stocks – when you're living on the money from those investments, the idea that they might suddenly plummet in value is pretty scary. But despite the risks, stocks are still a crucial part of any retiree's portfolio.

Reason No. 1: Diversification

Diversification is a way of managing risk by spreading your money out over a wide range of investment types. The idea is to put your money in investments that are likely to head in different directions at any given time. For example, take stocks and bonds. During times of inflation, stocks tend to go up in value while bonds tend to drop. During times of deflation, the opposite happens. So if you have some money in stocks and some in bonds, at any given time, some part of your portfolio will likely be going up in value (and making up for any losses on the other parts).

Studies have shown time and again that diversified portfolios strongly outperform non-diversified portfolios over the long term, and have less volatility. In other words, holding stocks in your portfolio actually reduces your overall risk as long as you also have other types of investments balancing them out.

Hand-drawn stock return chart

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Reason No. 2: Higher returns

Over the long haul, stocks produce significantly higher returns than bonds and other common investments. The historical average stock market return over long periods of time is around 7% adjusted for inflation, which is considerably better than what you can expect from bonds. And unlike bonds, stocks consistently beat inflation over the long-term – which means that at least your investments won't be shrinking in value along with your dollars.

Higher returns means that your money will be growing as it sits in your retirement accounts, so you'll be able to take out more money every year without risking a loss of capital. And a higher income is certainly something that most retirees want.

Reason No. 3: Dividends

If you pick the right stocks with an eye to generating income, not only do the stocks themselves increase in value, but you can get a regular payout in the form of dividends. A dividend is a distribution of a company's earnings paid out to its shareholders. The companies that regularly and consistently pay large dividends tend to be established, stable ones – in other words, exactly the kinds of stocks a retiree would want in his portfolio.

When shopping for dividend stocks, don't be lured in solely by a high dividend yield. Retirees are much better off with stocks that can keep on consistently producing dividends, rather than ones that produce very high dividends once or twice and then quit. Dividend aristocrats, which are companies that belong to the S&P 500 and have increased their dividends every year for at least the last 25 years, are usually great picks for retirees.

How to pick the right stocks

An S&P 500 index fund is an excellent default choice for anyone who wants a simple, easy way to dip a toe into the stock market. Retirees can also choose from a plethora of funds designed specifically for them; however, stick with passively managed funds to keep your fees low. If you're OK with a more complex portfolio, you might choose a few individual stocks such as the previously mentioned dividend aristocrats. However, the bulk of your stock money should be in heavily diversified funds to keep volatility as low as possible.

Finally, as you get older, reduce your stock holdings and replace them with bonds and/or cash equivalents. The older you get, the more important stability becomes and the less need you'll have for high returns. A simple way to figure out the correct proportion is to subtract your age from 110 and keep that percentage of your portfolio in stocks. For example, a 70-year-old would have no more than 40% of his holdings in stocks; an 80-year-old would have 30% of his holdings in stocks. With this approach, you can enjoy the benefits of stock ownership while minimizing the drawbacks.

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