Investing Your Nest Egg Where should I invest my retirement nest egg so it is safe?

How much can I take each year without ever running out?

Welcome to the wonderful world of retirement. These are the two eternal questions posed and faced by all retirees. For time immemorial, the simple answer was to invest retirement proceeds in utilities, preferred stock, REITs, bonds, and other dividend-producing, interest-paying securities. You took the interest and dividends as income for the year and let the principal ride. The emphasis here was on income, not growing the base of the investment. Investing for growth meant taking more risk, and risk was to be avoided at all costs, or at least so said the Wise retirement advisors who held sway in Americans' psyches.

Times have changed, and the approach that once seemed so attractive and so sensible no longer holds sway. Companies no longer promising or even attempting to provide any dividend growth, deregulation of the utilities, increasingly volatile bond markets, low interest rates, inflation, and increasing life spans have all reared their ugly heads at one time or another to undermine the security of a "low-risk, income-only" investment strategy for retirees. Many financial experts believe the "low-risk, income-only" strategy may pose the ultimate threat to retirees because you could run out of money before you run out of time to spend it. In essence, some retirees are taking the greatest risk of all, not taking enough risk with their retirement money.

Life expectancies have increased dramatically over the years. A 62-year-old retiree today can expect to live into her 80s and even her 90s. That means required income must continue for 20 to 35 years, and much longer for those who retire at earlier ages. While an "income-only" portfolio may produce desired income in the early retired years, it could fall woefully short in later years.

As an example, a low-risk, all-bond portfolio with an average return of 6% might throw off enough income for a retiree today. Nevertheless, at a modest inflation rate of 3% per year, every $1,000 produced by that portfolio will only be worth $554 in 20 years. Worse, the principal available then for reinvestment will be the same as it is today because it did not grow through the years. As purchasing power declines, a retiree using such a strategy almost certainly will have to dip into principal to sustain her lifestyle, and the use of that principal will definitely shorten the life of her portfolio. Conversely, an all-stock portfolio may produce growth from which one may take income. Yet stocks can plunge in value overnight, and they can stay down for five years or longer. To a retiree, that, too, can be a devastating result.

So what is the answer? It is called asset allocation.

Asset allocation means part of our investment portfolio should go to each of the three primary investment markets: Stocks, bonds, and cash. In theory, these markets do not move together. As one is at a high, another is at a low, and the third is somewhere in between the other two. By having a portion of our money in all three areas, we minimize our downside risk while achieving necessary portfolio growth. We and we alone decide how much of our total portfolio we want in each area, and then we allocate that percentage to each. Periodically, typically once each year, we see what happened, because markets are doing their crazy "up and down" thing, we will find that our original allocation has changed. At that point we rebalance our investments to restore our desired percentages.

That means we sell our winners to replenish our losers. In other words, we buy low and sell high. Now is not that a great thought, and yet so wise, too? The trick is to decide how much to place in each sector, and that is something everyone has to decide for himself or herself. No one else can really do it for you. There just is not a "right" answer or "one size fits all" solution to this conundrum.

Conventional wisdom held that the way to allocate money was to subtract your age from 100, and devote that portion to stocks. Therefore, a 50-year-old would have 50% of her portfolio devoted to stocks. A 70-year-old should only have 30% devoted to stocks. Then, as we know, people started living longer, and the number to subtract from became 110. Perhaps there is some vague broad-stroke sense to that, but in reality, as retirees we must determine the allocation that allows us as individuals to sleep well at night while still generating the income and portfolio growth required for the rest of our lives.

A wise retirement allocation is really determined no differently than it is for any other investor at any other age. We seek the mix that fits our risk tolerance for losing money yet still achieves our objectives. In this case, we want growth and income. To achieve both, we look at total portfolio return and adjust for risk by controlling the ratio of stocks within that portfolio. A major factor in that equation is the desired withdrawal rate from that portfolio, a topic covered next in How Much Are You Going To Take?