The right time for a conservative portfolio

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NEW YORK (Money) -- Question: My husband and I disagree on when it is time to diversify our retirement accounts. We are 46 and plan to work until full retirement age. Our accounts are invested mostly in mutual funds that are solely invested in stocks.

We don't want our retirement nest egg taking a hit from a market downturn at a time when we are getting ready to retire and can't wait for the market to turn back around. At what age or point does one begin to diversify accounts to include bonds?

The Mole's Answer: Answering this question is one of the most valuable services a financial planner can provide to their client. The answer is a combination of mathematical probabilities and the much more complex understanding of the emotional component. I'll explain a bit and then give you some guidelines to make the decision for yourself.

You have almost 20 years before you will need this money. Looking back over time, the worst the stock market has done is to beat inflation by 1% per year, while the worst bonds have done is to lag inflation by 3% per year. Thus, the mathematical answer tells you the odds are better if you keep your money in the stock market.

I think this historic framework is a good starting point. I also think it's important to keep in mind that history doesn't always repeat itself. For all of my clients, I make the pragmatic recommendation of keeping at least 10% of one's total portfolio in cash or fixed income. At the very least, it serves as a shock absorber for the portfolio and makes staying the course much more likely.

How much risk is right for you is dependent upon two things:

What is your willingness to take risk?

Since you have had 100% of your retirement account in stocks for some time, you probably have a high willingness to take risk. That means you can sleep at night when the market has one of those bear runs and you see the size of your nest egg shrink.

Measuring our willingness to take risk isn't easy. It's usually done by risk profile surveys, though they can be iffy. My personal results vary significantly from survey to survey, in that some say I'm the ultimate risk taker and others say I should keep everything in treasury bonds because I'm terrified of risk.

In my own practice, I ask people how they would feel if they saw their nest egg value cut in half. Most say they would stay the course and not panic and sell. I then point out that this was an intellectual exercise and the pain that is felt from actually losing half of your nest egg would be profoundly greater than any theoretical example.

A low willingness to take risk will likely be demonstrated by getting into the market when it has gone up and doing the panic-and-sell thing after it has plummeted. In the long run, a low risk taker is probably better off in bonds.

What is your need to take risk?

This is the critical question that is almost always overlooked. For example, I have a 75-year-old client who has a primary goal of making sure he has enough money to live comfortably for the rest of his life. He came to me with a large portfolio that could easily guarantee he met this goal. However, he had nearly everything in stocks.

I posed some unlikely, but not impossible, scenarios where the U.S. market could lose 50% or more of its value, causing his plan to fail. Since he had no need to take risk, we put enough of his portfolio in government-backed securities that would guarantee his success as long as the U.S. Government stays in business. We put the rest in diversified stock index funds.

The opposite example happens more frequently. When someone is nearing retirement and hasn't done so well in building a nest egg, they have a high need to take risk, in addition to acquiring some discipline to save. That bond fund isn't going to get them where they need to be.

My advice:

Consider the following as general guidelines:

• The closer you are to reaching your financial goals, the more conservative you want to invest, so more fixed income is appropriate. Don't take risks if you don't need to.

• The more likely you are to change the allocation, the more conservative you want to invest because you will be influenced by fear and greed to buy high and sell low.

• Always keep at least 10% in bonds or fixed income.

• Any money you need in the next five to ten years should generally be in fixed income, as the stock market is too risky in the short term.

• Once you pick an allocation, stick to it. Don't let emotions destroy your retirement goals by swaying you to go in and out of the market.

Finally, while not for everyone, lifestyle funds can offer a single solution in that they automatically get more conservative as you approach the time you will need the money. It's the auto-pilot way to invest.

Are you on track for an early retirement? Tell us why at millionaire@cnnmoney.com. Include your financial details and your family could be profiled in a future column of our Millionaire in the Making series.