Why the Fed's rate cut should scare you

Money Magazine senior writer Janice Revell

Ultimate Guide to Retirement

• Getting started
• 401(k)s & company plans
• Investing
• Annuities
• IRAs
• Self-employment plans
• Pensions and benefit plans
• Social Security
• Insurance
• Estate planning
• Living in retirement
• Getting help

More from Money Magazine

Will your hometown be a boomtown again? When marriage means medical bills 5 reasons banks don't get it

Best Places to Live Current Issue Subscribe to Money

NEW YORK (Money) -- If you're saving for a retirement decades away, Thursday's big drop in the stock market shouldn't worry you too much.

But something did happen this week that you can't afford to ignore: the Federal Reserve's rate cut.

The Fed's actions could very well be ushering in a new era of inflation - and that is horrible news for your retirement portfolio.

When you save for retirement, you're saving for a lifetime supply of food, shelter and golf fees. Over time, the prices for these things only go one way: up.

The risk is that the value of the investments you're now stockpiling to pay for them may not increase at the same pace - leaving you with only enough money to pay for nine holes' worth of green fees.

With its rate cut this week, the Fed has made it clear that staving off recession is more important than reining in inflation.

But while the typical recession has lasted 18 months on average (not including the Great Depression), inflation can dog your finances for a long, long time.

Our last inflationary cycle stretched out for almost 20 years, from the mid-1960s to the early 1980s.

I'm not saying that the Fed's quarter-point rate cut is going to turn America into Argentina overnight. But you'd be wise to start taking steps to guard against the possible uptick in inflation.

When the stock market gets especially volatile (as it is right now) there's a natural temptation to flee into conservative investments like government bonds. That's understandable - you have to be able to sleep at night.

But the risk of loss is only one of the two big risks you face. The other is the risk of inflation - and it can be just as damaging.

To see why, consider that the average rate of return on the 10-year Treasury bond has historically outpaced inflation by only about one-and-a half percentage points.

Right now, for instance, the 10-year Treasury is yielding about 4.4%, while the inflation rate is running at 2.8%.

Sure, a Treasury bond is a safe investment if you hold it to maturity. But unless you've already racked up more money than you can possibly spend, that yield will not even get you close to the stash you'll need to live on in retirement.

So to protect your portfolio simultaneously against both the risk of loss and inflation, you must be diversified.

Bonds, for instance, frequently move up when stock prices are heading south, dampening your risk of loss. But at the same time, bonds, more than any other type of investment, can get hammered by rising inflation.

Think back to the early 1980s, when inflation was running at around 10%. At the time, even ultra-safe US Treasuries were sporting double-digit yields, which certainly looked tempting. But to entice new bond investors, the government had to keep ratcheting up the interest rates they offered on new bond issues. That made the prices on existing bonds plummet (since the interest they paid was less attractive) and bond investors took big losses.

Over the longer run, common stocks have done a much better job of protecting investors from high inflation, since their returns are generally about four to five percentage points higher than high-quality bonds. But of course, stocks can crash in the short-term.

Real estate investments, such as REITS or real estate funds, typically perform the best of all types of investments during times of high inflation. But like stocks, they also carry a significant risk of short-term loss.

Add all of this up and it means that you've got to have a smattering of all asset classes. Ideally, your portfolio will hold a mix of small- and large-cap U.S. stocks, a smattering of international stocks, some REITs and some bonds.

The exact investment mix that is right for you will depend on several factors including how much time you have until retirement, the degree of risk you're comfortable taking, and other sources of retirement income you might have.

Roughly speaking, though, the targets for your retirement asset allocation might look like the following:

At 30, you might aim for 75% stocks, 10% REITs and the rest in bonds.

At 45, you'd shift to 70% in stocks/REITs, and at 60, you'd reduce your stock/REIT allocation to 60% of the portfolio (Corrected).

Even if you're already retired, you'll want to keep some exposure to regular stocks and real estate to give your portfolio a chance to generate enough income to keep pace with inflation.

I certainly can't predict the future, and neither can anyone else. One thing I do know, however, is that inflation now presents more of a threat to your retirement portfolio than it has in a long, long time.

Follow the strategies above and you'll be well on your way to handling anything the economy dishes out.

Questions or comments about retirement? Send e-mails to jrevell@moneymail.com.