Build a Sturdy Retirement Portfolio

The old rule for asset allocation in retirement went like this: Subtract your age from 100, and devote that percentage of your portfolio to stocks. That means a 70-year-old investor would have 30 percent of his or her assets in stocks and the rest in bonds.

These days, financial planners are rethinking the conventional investing wisdom that says as you age, you should dramatically decrease your exposure to stocks and load up on bonds. "The old rules of thumb don't apply," says Steven Dimitriou, managing partner of Mayflower Advisors, an investment advisory firm in Boston. "The fact is that people are living longer now; things like medication are taking up a larger portion of their income. You can't just sit on your laurels and buy a bunch of bonds anymore."

Longevity has a lot to do with it. Consider this: In 1955, Americans lived an average of 69.6 years. By 1995, the average life expectancy had risen to 75.8 years, and by 2005, it had climbed to 77.8 years, according to the National Center for Health Statistics. "Now, instead of managing your finances for 10 years, we're talking about 35 years," says Ron Florance, director of asset allocation and strategy for Wells Fargo Private Bank, who assumes life expectancies of 100 for his clients. (Many financial planners say newly retired investors should plan for at least 30 years in retirement.)

So how should a retiree divvy up his or her portfolio between stocks and bonds? The answer depends heavily on an individual's risk tolerance, but a stock allocation that falls between 40 percent and 60 percent is suitable for most investors, says Stephen Barnes of Barnes Investment Advisory in Phoenix. (Click here to see Barnes's specific allocation suggestions.) "One of the biggest mistakes retirees make is getting too conservative on the day they retire," says Barnes. "We believe strongly that there's very little difference between a preretiree's portfolio and a retiree's portfolio. Change, if any, should be very gradual over the years."

Combating inflation. You don't need an economics degree to understand the effects of inflation—just visit the grocery store or the gas pump. Inflation is also bad news for your retirement portfolio. That's because the cost of living in your early retirement years will considerably outpace that of your later years. Consider that in 15 years, an expense that currently costs $100 will set you back $180, assuming an inflation rate of 4 percent.

At last month's Morningstar Investment Conference in Chicago, Mohamed El-Erian, co-chief executive officer of bond-fund giant PIMCO, spoke of major changes afoot in the global markets, including the return to an era of accelerating inflation. "This is not noise; these are signals, and understanding these signals is the difference between superior performance and the opposite," he told investors during a speech. El-Erian said investors need an inflation-protection strategy going forward.

Inflation hedges include treasury inflation-protected securities, or TIPS, which increase principal and interest payments in step with inflation, as well as "real assets," such as commodities and real estate, which tend to retain their value during inflationary periods. Some financial advisers recommend a small allocation—say, 5 to 10 percent—to such alternative asset classes. However, assets such as TIPS aren't a one-shot solution, says Dimitriou. "The concept is fantastic, but if you think you can live off of TIPS and keep up with inflation, you're crazy," he says. "Don't think you can rely on them to solve the inflation problem."

Another way to fight inflation, says Florance, is by keeping a large share of your portfolio in stocks. "Here are some ballpark numbers: Figure that in retirement, you'll consume 4 percent of your portfolio annually to maintain your lifestyle. Add 3 percent for inflation and 1 percent for the cost of managing your money, and that all adds up to 8 percent—what your portfolio needs to earn," he says. "A portfolio returning 8 percent annually is not a 100 percent bond portfolio. It's going to require growth assets." Generally speaking, says Florance, "growth" assets—such as stocks, high-yield bonds, and commodities—shouldn't drop below 50 percent of a retirement portfolio.

Hedging stock-market risk. Near-term fluctuations in the stock market don't mean much for young investors with a half century of compounding growth ahead of them. But the danger for investors in retirement is the prospect of having to sell holdings in a market downdraft. "The worse thing you can do is lock in that loss by cashing out," says Dimitriou.

Tom McGuigan, a Connecticut-based financial planner with Burns Advisory Group, says the firm has come up with a strategy to solve that issue: a five-year cushion. "We carve out the next five years' worth of income needs from the portfolio," says McGuigan. "Let's pretend an investor needs to draw $50,000 a year from the portfolio. We multiply that by five years and set it aside in a fixed-income portfolio that's more stable and won't fluctuate as wildly as stocks."

The rest of the investor's money goes into a diversified portfolio of stocks funds and real estate. "What we've done is bought ourselves time—five full years to let the stock market do what it does. Meanwhile, the investor is sitting on five years of stable investments."

Staying diversified. Since different types of stocks take turns leading the market—and those shifts are largely unpredictable—it makes sense to keep your retirement portfolio stocked with funds representing a variety of investing styles and company sizes. "There should be a wide range of asset classes, the idea being that we don't know ahead of time which will outperform, so you need exposure to them all," says Barnes.

For the portion of your portfolio devoted to stocks, he recommends allocating 60 percent of assets to large companies, 30 percent to small and midsize companies, and 10 percent to emerging markets. "We no longer differentiate between foreign and domestic stocks—globalization has reached the point where it's getting too difficult to draw hard lines," Barnes says.

Shoot for variety not only in company sizes but also in investing styles: Hold funds that specialize in fast-growing companies, as well as those that focus on finding undervalued firms (some funds invest in a combination of both).

When it comes to your bond money, Barnes suggests keeping 20 percent of assets in high-yield bonds, 20 percent in foreign bonds, and the balance in investment-grade IOUs.