Time to Re-Think Role of Stocks in Retirement

What role should stocks play in your investment plan for the last years leading to retirement?

The conventional thinking has been to roughly take your age and subtract it from 100. The result is the percentage of stocks in your retirement portfolio.

The rest of your retirement portfolio is primarily bonds and cash. Some would argue for a small portion of real estate and precious metals.

More in Stocks?

However, for most people bonds and cash are the two main asset classes that make up their retirement portfolio.

Stocks are considered too volatile for short-term investors (under five years), which is why for many years retirees were warned off holding a large percentage of stocks.

Several things have changed and it is time to rethink conventional wisdom.

First, people are living much longer and a five-year holding period for stocks after retiring in the mid-60s is not a problem for many of today's healthy retirees.

The greater danger is out living their money.

Inflation Danger

Second, there is a real danger we may be entering an inflationary cycle.

The last cycle of inflation ended some 30 years ago after a two-decade run.

For retirees with most of their assets in fixed return investments (bonds, bank CDs), inflation is a killer.

Rising inflation devastates bonds. As inflation rises interest rates rise also, meaning new bonds pay higher returns. This makes older bonds worth less.

If you have a 10-year Treasury Note paying 4.5 percent and inflation rises to 4 percent, new bonds will pay a premium above the 4 percent to attract new investors.

Rising Costs

This makes your 4 percent bond worth much less. If you hold it until maturity, it will not pay enough to cover the rising cost of inflation and the taxes.

Over time, stocks have proved an effective hedge against inflation. Companies can raise prices to account for the rising costs associated with inflation.

Bonds have little or no flexibility.

In particular, companies that are in non-cyclical businesses will do well in tough markets. These companies make and sell products and services that consumers and businesses continue to buy and use regardless of the economy (think toilet paper).

Inflation Hedge

Real estate has been a historical inflation hedge, however if you invest directly (buy rental houses or commercial property, for example) you may find it difficult to sell the property if you need to cash out.

Real estate investment trusts (REITs) solve the liquidity problem, but can be volatile over the short term. For more information on REITs, see this article.

What is the correct mix of stocks, bonds, and other assets for a person nearing or in retirement?

That will depend on your personal situation and tolerance for risk.

However, given that people are generally living longer and there is a real threat of increased inflation, investors should consider a higher percentage of stocks than 100 minus your age.