SAVE   |   EMAIL   |   PRINT   |   RSS  
Keeping the nest egg safe
A reader asks how to diversify his portfolio to protect retirement savings from a market woes.
November 8, 2005: 12:56 PM EST
By Walter Updegrave, CNN/Money contributing columnist

Sign up for the Ask the Expert e-mail newsletter

NEW YORK (CNN/Money) - The balances of our IRA and regular taxable accounts have grown large enough that a severe market downturn would be devastating for me and my wife. How can we protect our retirement savings? Should we consider derivatives and options, or is there something else we can do?

-- B. deLoeuf, Missoula, Montana

It's only natural that as your retirement savings begin to grow that you become more anxious about incurring losses. After all, even though a 20% loss is still a 20% loss regardless of the size of your account, seeing the balance of a $500,000 retirement stash drop $100,000 is a lot more gut wrenching than watching a $50,000 account decline by $10,000.

But it's precisely because more is at stake both financially and emotionally when you're dealing with bigger bucks that you've got to step back a moment and devise a strategy for dealing with investing risk that's based on logic, not fear and emotion.

So let's go over your choices.

One would be to buy a specialized investment like a derivative or option that's designed to protect a specific part of your portfolio. For example, if you own General Motors (down $0.64 to $26.11, Research) stock and you're worried that all the talk of GM's health-cost and pension problems will continue to drive the stock below its recent price of $27 or so a share, you could buy a "put" option on GM shares at say, $25. Such an option would give you the right, but not the obligation, to sell GM shares at $25 for a specific period of time.

In effect, you would be buying insurance that would limit your potential loss to $2 a share. Alternatively, if your overall stock holdings were similar to a broad index like the Standard & Poor's 500, you could protect the value of your entire portfolio by buying a put option on the S&P 500 index.

While this type of insurance can work in some situations, I don't think it's appropriate for individuals who are investing for long-term goals such as retirement. For one thing, you've got to pay a premium to buy these options. And if you want to renew the protection after the option expires, you've got to pay that premium again—and again, and again as long as you want that insurance.

This makes no sense to me because if you're investing for the long term, why pay to protect yourself against short-term fluctuations that don't mean very much over a long period of time?

Or you could move nearly all of your portfolio into "safe" investments like CDs, money-market accounts or short-term bonds. That will protect your principal all right. But it will also stunt the long-term growth of your portfolio. Which means you may not accumulate a large enough nest egg to support you comfortably in retirement, and your savings may run out while you've still got a lot of living to do.

So what's the solution?

I'd recommend a sensible asset allocation strategy -- that is, divvy up your assets among stocks, bonds and cash so that you have enough exposure to equities to gain the long-term growth potential you need, but you also have some protection against market setbacks.

This strategy also works as a hedge in another way. Although stocks have historically delivered the highest returns of all financial assets by a large margin, there's no guarantee that will happen in the future -- or, if it does, that stocks will provide as big an edge. Thus, having some of your money in bonds means your portfolio still has a good shot at long-term growth even if stocks don't romp as they did in the past.

Find the right allocation

As for setting the allocation that's right for you, it really comes down to how long you'll have your money invested and what sort of short-term ups and downs you're willing to accept in the value of your portfolio. The longer your investment horizon, the more you want in stocks. The less volatility you can stomach, the more in bonds. To translate this principle into actual percentages of stocks and bonds, I have two recommendations.

The first is to go to our Asset Allocation tool. Just answer a few questions to judge your time horizon and risk tolerance and, as Emeril would say, Bam! You get instant advice on how to divvy up your portfolio among different types of stocks and bonds.

Or you can check out the Dream Retirement package in the November issue of MONEY. You'll want to pay particular attention to The Right Investment Strategy and its companion piece, A Plan For Every Stage. After reading those stories, you'll come away with allocation advice you can apply to your situation, as well as recommendations for specific investments to carry out your strategy.

One final tip: After you've settled on a stocks-bonds mix that's right for you, you may have to adjust it from time to time. For example, if stocks have a big run and bonds suffer, your portfolio may become a bit heavy in equities. Similarly, as you age, you may also want to tilt your mix a bit more toward bonds—that is, sell of some of your stock holdings and plow the proceeds into bonds—to prevent large setbacks when you're on the verge of retirement.

Of course, selling stocks or bonds in which you have gains could generate taxes. So to the extent you can, you would want to adjust your portfolio's mix by investing new money in whichever asset you need to bulk up. If your proportions have gotten too far out of whack to do that, then you should try to make the necessary adjustments in your 401(k), IRA or other tax-advantaged account.

Since gains in such accounts are taxed only when the money is withdrawn, you can move money from stocks to bonds or vice versa to arrive at the stocks-bonds mix that's right for your portfolio overall -- that is, both taxable and tax-advantaged accounts -- without creating taxable gains. Not only do you keep your allocation on track, you do it in a way that keeps Uncle Sam's hand out of your pocket and leaves more of your money in your portfolio generating gains, a win-win for you.

__________________________

For all the latest headlines in Ask the Expert, click here.  Top of page



YOUR E-MAIL ALERTS
Follow the news that matters to you. Create your own alert to be notified on topics you're interested in.

Or, visit Popular Alerts for suggestions.
Manage alerts | What is this?