After working a lifetime and scrimping and saving to build up a retirement nest egg, most retirees want to sit back and enjoy the good life without any worries about running out of money. Many of those retired investors believe that the best way to ensure that they'll be able to outlive their savings is to eliminate as much risk from their portfolios as possible, protecting their investment principal at all costs.
Yet many people don't realize that the biggest risk to their retirement could be investing too conservatively. Especially in today's market environment, in which high levels of risk-free current income are nearly impossible to find, settling for the tiny guaranteed income that you'll get from the safest investments has the surprising effect of leaving you far more at risk of running out of money in the long run. By contrast, being even slightly more aggressive with your investment portfolio could be the key to protecting your nest egg and preserving it throughout your retired years.
The disappearance of dependable income
Historically, it was much easier for retirees to find income sources that had both low risk levels and high yields. Following the spike in inflation in the early 1980s, even Treasury securities paid high interest rates, with longer-term Treasuries giving investors double-digit percentage yields for decades. Even after inflation subsided in the 1990s, you could routinely find five-year Treasuries paying between 5%-8%. Bank CDs often paid rates in line with or even higher than these rates, despite the fact that they were FDIC-insured and therefore free of default risk.
The consequence of these rates was that retired investors could afford to take part of the income they received from their investments and use it for spending money while still having an unspent portion of their interest available to reinvest. That way, their nest egg would rise in value steadily, helping retirees keep up with rising costs as they aged.
Since then, though, low-risk investments have been a lot less generous with their interest. With current rates between 1%-2%, bank CDs and Treasuries don't pay enough interest to fund even half of a typical retiree's annual withdrawals from their retirement accounts, let alone keep up with the impact of inflation and taxes on their spending power.
In response, many investors have turned to higher-risk fixed-income investments, including longer-maturity bonds and lower-quality corporate junk bonds. Long maturities typically have slightly higher yields, but they're more vulnerable to interest rate increases, as you've effectively locked in a subpar rate for a longer period of time. As for junk bonds, they do pay higher yields, and as long as times are good, they can provide at least some protection from inflation while also helping retirees meet their cash needs. But high-yield bonds also carry greater risk that the issuing company will default on its debt obligations, leaving retired investors out in the cold.
The long-term way to reduce your retirement risk
The seemingly contradictory solution to retirees' risk problem is simple: To cut the risk of running out of money, you have to embrace the risk of the stock market to a larger extent than many people feel comfortable doing. By doing so, you add the potential for growth in your portfolio to the income it can generate.
The thing about a bond is that it won't provide growth. If you buy a typical bond for $1,000, it'll pay you back the same $1,000 when it matures, having made interest payments along the way.
But many stocks pay current income and have the potential to see their share prices grow over time. Many dividend stocks have yields that are well above the 1%-2% that five-year Treasury bonds have paid recently, and they've also enjoyed share-price advances during the bull market that have added greatly to their total returns. Retirees who have invested in dividend stocks have been rewarded for taking the risk, as the value of their portfolios has increased along with their income stream.
Obviously, putting more of your money into the stock market carries risks of its own. After a five-year bull market, many believe stock prices are too high, and corrections and bear markets are inevitable in the long run. Yet even many retirees have time horizons measured in decades when it comes to how long they need their money to last, and over those periods of time, stocks have historically far outpaced the returns you can get elsewhere -- even in relatively weak periods for the market.
Running out of money is a huge risk in retirement, and being too conservative with your investments can, paradoxically, increase that risk. By taking on the right amount of stock market risk in your investments, you can greatly reduce your risk of running out of money and instead live out the retirement you've always wanted.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.