As you get older, it seems that no one wants you to have any fun. You have to be more careful about your health. When you exercise, you're supposed to make sure your heart rate doesn't get too high. Some folks even want to take away your driver's license once you get to a certain age.
With investing, seniors face the same challenge. After a lifetime of investing experience, and after you've gotten familiar with dozens of companies that have served you well, you may well hear financial planners telling you that you should bid farewell to those trusty stocks -- even blue chips like Johnson & Johnson
One size fits all?
Sure, there's something to that logic -- as the ongoing bear market has made perfectly clear. After all, when you're young, you have decades before you'll need the money you set aside for retirement. With all of that time ahead of you, you can afford to take some big risks. Even if your investments do badly at first, you can wait for them to turn back up again. Your timeline and risk profile would accommodate such volatile stocks as MercadoLibre
Conversely, as you approach or enter retirement, you no longer have the luxury of weathering long downturns in stocks. You need that money now for your living expenses. If you were unlucky enough to get hit by the next recent downturn, you may have to sell at very low prices just to pay your bills.
The concept that you should reduce your allocation to stocks as you age is so engrained in common wisdom that certain mutual funds do it automatically. So-called target retirement funds, which we've discussed in the past in our Motley Fool Rule Your Retirement newsletter, are designed to change their investment strategy gradually over time to accommodate your changing risk tolerance. Yet even though these funds make investing very simple, they may not be able to handle all of your specific needs.
There's one big problem with reducing stock exposure as you get older: Although falling stock prices may seem like the biggest danger -- especially now -- people face other risks as well as they move toward retirement.
Even if your portfolio is adequate to cover your costs when you're just about to retire, the threat of inflation is ever-present in retirees' minds. With a $1 million portfolio invested entirely in ultra-safe Treasury bills, you won't even earn $10,000 to cover expenses each year, thanks to rock-bottom interest rates. Moreover, the value of your principal will stay locked at that $1 million mark, and it won't be long before rising costs eat away at its purchasing power.
Stocks, on the other hand, offer not only prices that rise over time, but also rising dividends. Companies such as Coca-Cola
On the other hand, if you've saved up a substantial nest egg for your retirement, you may be able to tolerate the risk of market downturns. For instance, a typical plan for a retiree might have you sell some of your stocks every year to supplement your retirement income.
However, you can hedge the risk of a market drop by keeping enough money in safer securities to give your stocks a chance to recover. Even though this strategy involves keeping several years of expenses in bonds, CDs, or cash, it still gives you the ability to keep a substantial fraction of your portfolio in assets that will provide you a better return.
As an example, if you had retired in 2007 following this strategy, you could choose not to sell stocks now, waiting until the market recovers to sell and replenish your cash reserves.
Rules of thumb are helpful for beginning investors. To get the best results, however, you have to know when to break those rules. By weighing the risks of different investment strategies, you can pick the one that will work best for you. And you won't have to give up the fun of stock investing, no matter how old you get.
Learn more about target retirement funds in our retirement newsletter, Rule Your Retirement. It's a paid service, but you can get a free preview with a 30-day trial. There's no obligation to subscribe, and a trial gives you an all-access pass to the service, back issues, calculators, and discussion boards.
Mercadolibre is a Motley Fool Rule Breakers recommendation. Cemex is a selection of both Motley Fool Stock Advisor and Motley Fool Global Gains. Coca-Cola and USG are Motley Fool Inside Value recommendations. Johnson & Johnson, Coca-Cola, and Procter & Gamble are Motley Fool Income Investor recommendations. The Fool owns shares of Procter & Gamble and Cemex. Try any of our Foolish newsletter services free for 30 days.
This article was originally published on Apr. 5, 2007. It has been updated by Dan Caplinger, who doesn't own shares of the companies discussed in this article. The Fool's disclosure policy is appropriate at any age.