MONEY Ask the Expert

Reasons to Cut Back on Stocks in Retirement

Q. Why is the recommended mix of stocks and bonds any different at the beginning of my career than at the start of retirement? I don’t understand why I should reduce my exposure to stocks when I retire, as I’ll still have 30 years of investing ahead of me. — Gordon Groff, Lancaster, Pa.

A. You’re right. You should be investing for the long term — both during your career and after you retire. Still, there are some key differences between those two stages of life that argue for gradually scaling back on equities after you retire.

The single biggest difference is that you have a lot more flexibility during your career when it comes to retirement planning. For example, if you have the bulk of your retirement accounts in stocks and the market tanks, you’ve got plenty of options for rebuilding the value of those accounts.

With years of work still ahead of you, you can simply sit back and wait for the market to rebound and eventually climb to higher ground. Or you can pump up the amount you contribute to your retirement accounts, which will hasten the recovery of your balances.

If worse comes to worse, you can always postpone retirement for a year or two, which will give your nest egg a chance to grow through a combination of additional savings and a few extra years of investment returns.

But if your savings are heavily invested in stocks in retirement and the market takes a dive, you don’t have nearly as much wiggle room.

Unlike during your career when you’re still putting money into your 401(k), IRA or other accounts, you’ll be pulling money out of your nest egg once you retire. And that creates a very different dynamic.

Related: Retirement checkup for the new year

Specifically, the combination of investment losses from a market downturn, plus withdrawals from your account for retirement living expenses creates a double-whammy effect that can decimate the value of your portfolio and dramatically increase your chances of outliving your dough.

As a result, the same market meltdown that may be very unsettling during your career can be absolutely devastating after you’ve retired, perhaps even forcing you to radically scale back your standard of living to avoid running through your money too soon.

Here’s an example. Let’s say you retire at 65 with $500,000 in savings from which you plan to withdraw an initial 4%, or $20,000, that you will increase annually by the inflation rate to maintain your purchasing power. And let’s further assume that you would like your savings to support you at least 30 years.

If you plug that scenario into a good online retirement calculator, you’ll find that the chances of your nest egg lasting 30 years are roughly the same — just under 80% — whether you invest 80% of your savings in stocks and 20% in bonds or split it 50-50 between the two.

And although the calculator doesn’t show this, it’s also true that if all goes well and there are no major blowups in the market, the higher returns stocks can deliver might allow you to draw even more from your nest egg than had you gone with the 50-50 mix.

Related: Market timing — Not a good retirement strategy

The problem is what happens to those odds if things go badly. For example, if you had retired at the beginning of 2008 with 80% of your savings in stocks and 20% in bonds and embarked on the withdrawal scenario above, at the end of the first year of retirement the combination of a $20,000 withdrawal and a 30% investment loss would have left you with a nest egg worth roughly $340,000 — a 32% decline in a single year.

If you continued to withdraw $20,000 and increased annually for inflation of, say 3%, the chances of your savings lasting the next 29 years to age 95 would plummet from a little less than 80% to just under 40%.

By contrast, had you invested half your savings in stocks and half in bonds, the combination of your initial withdrawal and the market downturn would have left you with a nest egg worth a bit more than $400,000.

The probability of your money lasting to age 95 would decline. But since your nest egg wasn’t whacked as hard, the chances would drop to just over 50%.

Clearly, in both cases you would have to make some adjustments — going without an inflation increase for a few years, reducing your withdrawals outright or perhaps even taking on part-time work.

The difference is that with the more conservative portfolio, the compromises you would have to make to your retirement lifestyle wouldn’t have to be as severe. And you wouldn’t be as vulnerable to potential market setbacks in the future.

Now, does that mean that it can never make sense to invest somewhat aggressively in retirement? Of course not.

Related: Emergency funds: Risk versus returns

If income from Social Security and a traditional company pension covered all or nearly all of your annual expenses, then theoretically you may be able to invest quite heavily in stocks.

After all, if your retirement accounts suffered serious losses, you would still have enough income apart from savings withdrawals to maintain your lifestyle (although even then you would have to consider whether you would be emotionally okay watching your nest egg’s value decline by 30% or more).

Bottom line: If you’ll have lots of income flowing in throughout retirement from guaranteed sources — or your nest egg is so large or withdrawal rate so small that your chances of depleting it are truly minimal — then I suppose you could invest the same way late in life as you did at the beginning of your career. But if that’s not the case — and I suspect it’s not for most of us — the more prudent approach is to scale back your stock exposure as you near and enter retirement.

MONEY Ask the Expert

Retirement Savings Checkup for the New Year

Q. I save 15% of my salary each year in my 401(k), my company matches another 4.5% and I contribute the max to a Roth IRA. Am I doing enough to safely retire? — Dave K., Jacksonville Beach, Fla.

A. If you continue at the rate you’re saving, it’s hard to imagine you’ll come up short at retirement time. After all, you’re socking away money at more than double the rate of most 401(k) participants, plus you’re funding that Roth IRA.

But as important as diligent saving is, your savings rate alone can’t tell you whether you’re on track for a secure retirement. To know for sure, you’ve got to undertake a more comprehensive review of your retirement planning efforts.

You can do that by performing what I call my annual New Year’s Retirement-Planning Checkup. It consists of just three simple steps:

1. Figure the odds. There are so many unknowns and potential detours along the road to retirement — market setbacks, spates of unemployment, emergencies that drain savings — that you can never say that a secure retirement is a given.

Related: Take control of your spending

But by taking a look at where you stand now as well as the strategy you’re currently employing,you can get an estimate of the probability that you’ll be able to maintain an acceptable standard of living once you retire.

The easiest way to do such an assessment is to go to a robust online tool like our Retirement Planner or T. Rowe Price’s Retirement Income Calculator. You just plug in such information as how much you’ve already got tucked away in retirement accounts, the percentage of salary you’re saving now, how those savings are invested and the age at which you intend to retire, and you’ll get an immediate forecast of your chances of being able to retire on, say, 75% of your pre-retirement salary.

Aside from the obvious benefit of letting you know whether the path you’re on has a decent chance of leading to a comfy post-career life, this sort of evaluation has another advantage: by changing a few variables — your savings rate, how you invest, the age at which you retire, whether you work part-time in retirement — you can see how you might be able to increase your shot at a secure retirement.

This type of exercise is essential if you really want to know whether you’re making progress toward retirement. If you don’t feel confident doing this sort of number crunching on your own, then consider hiring a pro to guide you through the process. Just be sure to vet that adviser carefully.

2. Evaluate your portfolio. Although I’ve long noted that diligent saving is more crucial to retirement success than savvy investing, you nonetheless want to be sure you’re not undermining your savings effort with an inferior investment strategy.

Your first task on the investingfront is to makesure you’ve got a mix of stocks and bonds that’s appropriate given your age and risk tolerance.

Generally, the younger you are, the more of your retirement savings you’ll want to invest in stocks. As retirement nears and preserving your nest egg becomes a bigger priority than growing it, you’ll want to shift more toward bonds. There’s no single stocks-bonds blend that’s right for everyone.

As a starting point, you can check out the mix for a target-date retirement fund designed for someone your age. You can then see how such a blend might actually perform by going to Morningstar’s Asset Allocator tool. If you find that the mix you’re considering is too aggressive or too conservative, you can then adjust it.

You also want to be sure that your respective stock and bond holdings are properly diversified. In the case of stocks, for example, that means owning shares of both large and small companies as well as a broad range of industries. To gauge whether your portfolio is reasonably balanced compared with market benchmarks, plug your holdings into Morningstar’s Portfolio X-Ray tool.

Finally, take a hard look at what you’re shelling out in annual expenses.

Reducing the portion of your return that’s siphoned off by investment costs can have a big payoff. Lowering expenses from, say, 1.5% a year to 0.5% can increase the eventual size of your nest egg by roughly 20%. Fortunately, federal rules that went into effect in August make it much easier for 401(k) participants to see what they’re actually paying in fees and thus home in on the low-cost options in their plan’s investment roster.

3. Schedule updates. Once you’ve completed this checkup, you don’t need to fiddle with your retirement strategy every waking moment. Still, it is a good idea to check in occasionally just to be sure the plan you’ve put in place is working as expected.

So take a moment now to schedule a few specific times during the coming year — the end of a quarter, a birthday, wedding anniversary, whatever — when you can do quick re-assessment of where you stand and make tweaks if needed.

If you experience a significant change in your circumstances — say, moving to a new job or taking on a big new financial commitment — then you may very well want to perform a full-blown review.

Bottom line: There’s no way to eliminate uncertainty when it comes to retirement planning. But if you combine this sort of annual checkup with periodic monitoring throughout the year, you’ll dramatically improve your chances of getting, and staying, on the path to a secure retirement.

MONEY

Index Funds: A Simpler, Cheaper Way to Invest

I’m conflicted about whether I should invest in actively managed funds or index funds. Ideally, I’d prefer to keep things as simple and straightforward as possible. — Rusty, Albuquerque, N.M.

If you’re looking to keep things as uncomplicated and trouble free as possible — a perfectly reasonable goal, especially in these topsy turvy times — I don’t think there’s any doubt that index funds are the better choice.

In fact, even if simplicity isn’t an overriding concern, I still think you should consider keeping all, or at least most, of your savings in index funds that give you broad diversified exposure to the financial markets, or their ETF counterparts.

Why? Four reasons.

1. Greater certainty. One of the most valuable features about index funds is that you know exactly what you’re getting when you invest in one.

Want large-cap stocks? Fine, put your money in a Standard & Poor’s 500 index fund. Small caps? No problem, get a fund that tracks the Russell 2000 index or a similar benchmark for small companies.

Or you can make things really simple and invest in a total U.S. stock market index fund, in which case you get all U.S. stocks — large, small, value, growth, all industries — in a single fund. Throw in a total international stock index and a total U.S. bond market index fund, and you’ve got a fully diversified portfolio with just three funds.

You can build a portfolio using actively managed funds, but it requires more initial work and ongoing vigilance. The reason is that while you can get an idea of how an actively managed fund will invest based on its prospectus and its Morningstar category, the fund manager has wide leeway to stray from its specified strategy. And many often do.

During the go-go ’90s, for example, it wasn’t uncommon for value funds to juice their returns with growth-oriented tech stocks. To see if an actively managed fund has had a tendency to deviate from its stated investing style in recent years, you can plug its ticker symbol into the Quote box at the top of every Morningstar page and then click on the Portfolio tab.

So if you’re looking to build a portfolio that you can be sure will have specific types of stocks and bonds in specific proportions, you’ll have a much easier time doing so with index funds.

2. Lower costs. If keeping expenses down is a priority for you — and it should be — index funds are the hands down winner.

You can expect to pay roughly 1.5% or so a year on average for the typical stock fund and perhaps 0.75% or so for a bond fund. Index funds, by contrast, typically charge 0.25% to 0.5% a year, and by going to our MONEY 50 list of recommended funds you can find some that charge as little as 0.05%, or just $5 for each $10,000 invested.

To be fair, you can also find actively managed funds with fees considerably below the average. But you’re not going to find any with the razor-thin fees of index funds.

Related: What is the right mix of stocks and bonds for me?

Shelling out less in costs is a huge advantage, as every dollar of expenses is one less dollar of gross return that goes to you.

Over time, giving away more to fees can make a big difference. For example, if you invest $25,000 in two funds that both earn 7% annually before expenses and charge 1.5% a year and 0.25% respectively, after 20 years the fund with the lower fee tab will have an extra $19,000 or so.

3. Higher tax efficiency. In an attempt to deliver loftier gains to shareholders, many actively managed fund managers buy and sell shares frequently, hoping to rack up a profit or avoid a loss on each trade.

Even if that trading is successful after the costs it imposes, it can generate realized gains, which must be passed on to fund shareholders who must in turn pay taxes on them (assuming the fund is held in a taxable account).

If those gains are on shares held a year or less, they’re taxed at short-term capital gains rates, which today are taxed at a top rate of 35% versus a max of 15% for long-term capital gains.

Since index funds track a specific benchmark, such as the S&P 500 or Russell 2000, their selling is largely limited to getting rid of securities that leave the index or providing cash to redeeming shareholders, and even in those cases there are techniques managers can use to limit taxable gains.

The result is that index funds generate far fewer taxable realized gains.By deciding how long you’ll hold onto shares, you have more control over when you’re taxed and what rate you pay. If you want to compare the tax-efficiency of an index fund to an actively managed fund, check out the Tax tab on each fund’s Morningstar page.

4. Superior performance. If the three reasons I’ve already mentioned aren’t enough to bring you into the index camp, then this fourth one probably will: Over long periods, index funds tend to deliver higher returns than comparable actively managed funds.

Indeed, over the past 10 years, large-company index funds that track the S&P 500 or a similar index and small company index funds that mimic the Russell 2000 or other small-cap benchmark have beaten the average gain for comparable actively managed funds.

That said, over shorter spans it’s not uncommon for actively managed funds to post higher gains. And even over long periods, you’ll always be able to find some actively managed funds that due to the extraordinary skill of their managers or plain old luck have outgained index funds, although identifying such funds in advance is exceedingly difficult if not impossible.

Related: Why All-Cash Retirement Portfolios Can Be Risky, Too

The point, though, is that index funds’ lower fees and the fact their managers aren’t constantly buying and selling make it more likely that, on average, they’ll win out over actively managed funds in the long term.

Now, having made this case for index funds, I’d add that I don’t think you have to be such a purist that you sink every single cent you have into index portfolios. If you’re inclined to invest a portion of your money with a few managers who have solid long-term records and reasonable expenses, I don’t think you would jeopardize your financial future.

But if you want to keep things simple and straightforward and you want to increase your chances of earning competitive returns that will build your wealth over the long-term, I think your best shot is to create a diversified portfolio using broad-based index funds or ETFs as your building blocks.

MONEY

Retirement Investing in Uncertain Times

I’m 37, make $52,000 a year and have just begun putting money into a 401(k). With thirty years until retirement, I’m inclined to believe that a somewhat aggressive investing strategy will pay off in the long run. But given the immediate uncertainty in the economy and the market, am I better off investing in less risky funds in the short term? — Erik, Brooklyn, N.Y.

If you’re waiting for uncertainty, immediate or otherwise, to die down before you embark on your long-term investing strategy, you’re going to have a long wait. Things are never certain in the economy and the market.

Whether it’s concerns about the ability of a new Congress and a second Obama administration to get a handle on our massive budget deficit, worries about the effect Superstorm Sandy might have on future job growth, trepidation over the approaching fiscal cliff or anxiety stemming from the European debt crisis, uncertainty is a constant.

Or, to borrow a phrase from Gilda Radner’s classic Roseanne Roseannadanna character from the early days of Saturday Night Live: “It’s always something — if it ain’t one thing, it’s another.”

So the more important question you should be asking yourself is this: What kind of investor do you want to be, given that you’ll always have to deal with uncertainty? As I see it, you have two choices: you can be a reactive investor or a systematic investor.

Reactive investors spend most of their time figuring how to rejigger their investments to take advantage of new developments on the investing scene or to prevent those developments from hurting them.

Related: Worried about the Fiscal Cliff: Should I Sell?

If they see that inflation is ticking up or interest rates are starting to climb, they may shift money out of bonds and into gold or commodities. If they believe economic growth is weakening and the economy may be slipping into recession, they might get into defensive stocks or buy long-term bonds.

If you like making lots of moves with your investments, this is the right camp for you — for the reactive investor, investing is a never-ending guessing game. There will always be something going on in the economy or the markets that will catch your attention and require action.

The downside is that it’s tough — I would say virtually impossible — to make the right call consistently. Very often what seems like the obvious isn’t. Back in early 2009, for example, the last place most investors wanted to be was in stocks, which had just plummeted nearly 60% from their 2007 high. Moving to bonds or cash seemed a more prudent bet. Of course, we now know that since that low, stock prices have climbed more than 100%, while bonds gained about 28% and cash returned less than 1%.

A systematic investor, by contrast, starts with the premise that you can’t outguess the markets. The best you can do is set a strategy that will allow you to participate in the long-term upswing of stock prices, while hedging against the inevitable downturns by also holding some bonds and cash.

This type of investor doesn’t feel compelled to act every time a new piece of economic data flickers across his computer screen or a headline warns of impending doom.

Related: Retirement Savings: Quick Guide to How Much You’ll Need

Rather, the systematic investor realizes that one decision is key: determining the mix of stocks, bonds and cash that will give him a shot at reasonable returns while holding the risk of short-term setbacks to an acceptable level. Once he sets that mix, the systematic investor pretty much leaves it alone, except to rebalance periodically to bring the mix back to its original proportions.

If you prefer to be a reactive investor, I can’t offer you much advice. I don’t believe investors can consistently make the right moves in order to take advantage of market fluctuations. I think they’re more likely to end up hurting themselves.

No worries, though. There are plenty of brokers and other advisers out there all too willing to cater to the reactive investor’s need to act. In fact, the standard pitch from most of Wall Street and much of the financial services industry is that they know what moves to make, and for a price they’re willing to help you make the unending series of decisions you’ll face as a reactive investor.

If you want to join the systematic camp, however, then I suggest you stop obsessing about uncertainty and instead focus on creating a portfolio that makes sense for the long haul, in your case for someone with thirty or so years until retirement.

Related: Why There’s No Such Thing as Risk-Free Investing

Typically, retirement investors with that sort of time horizon invest between 70% and 90% of their savings in stocks with the rest in bonds, although the blend you choose should reflect how much you’re willing to see your account balance dip during market downturns. (To get a feel for the tradeoff between risk and return for different stocks-bonds mixes, you can check out Morningstar’s Asset Allocator tool.)

Of course, just because you arrive at the right mix doesn’t mean uncertainty will go away. It will always be there. But if you take the systematic approach, then at least you won’t have to react to it day after day after day.

MONEY

The Case for a Little Stock Market Optimism

Had you looked back in January to see how stocks did in the prior decade, you’d have been underwhelmed by annualized gains of just 3%.

Repeat that exercise today and you’ll get a decidedly brighter picture: The Dow has gained nearly 9% a year and the S&P 500 more than 8% now that the effects of the March 2000 to October 2002 bear market are more than a decade in the rearview mirror. That’s nearing the 9.8% historical average return of U.S. stocks.

No, this doesn’t erase the sting of the bursting of the tech bubble or the 2008 crash, nor does it mean you should put on rose-colored glasses as you read about 8% unemployment and a looming fiscal cliff. Nevertheless, the “lost decade” for stocks is no more.

So if the past wasn’t quite so bad, you ought to at least question the currently fashionable position that the future is really going to stink.

As governments worldwide struggle to pay down debt, the theory goes, economic activity and stock returns will be depressed for years. This is what bond guru Bill Gross and his colleagues at Pimco call “the new normal.”

Ben Inker, head of asset allocation at GMO, points out a problem with this assumption. “We don’t disagree when it comes to expectations for economic growth,” says Inker. “Where we disagree is whether the new normal has to have a bad impact on stock returns.”

Research by a team at the London Business School showing no relationship between how fast economies grow and how well stocks perform supports his view. Case in point: Since 1985, the U.S. economy grew less than a third as fast as China’s, yet American stocks gained more than twice as much as Chinese shares.

Related: Investing in China: Handle with Caution

Inker’s firm forecasts that over the next seven years, high-quality U.S. stocks should produce “real,” or inflation-adjusted, returns of 4.4% a year while foreign shares return 5%, based on factors including price/earning ratios. Again, that’s close to, though still less than, long-term averages.

Duncan Richardson, chief equity investment officer at Eaton Vance, argues the U.S. is “the most attractive major market when it comes to the fundamentals.”

What’s more, sentiment, as measured by money flowing into (or actually out of) stock funds, is as bad as it’s been in more than two decades. Most analysts believe that’s really a bullish sign.

Related: How do I make money investing?

This doesn’t mean it’s all smooth sailing ahead. Europe’s recession and China’s decelerating growth rate are cutting into U.S. corporate earnings this year. Profit growth for S&P 500 companies is expected to reaccelerate in 2013, but that assumes things don’t get worse from here.

So, yes, the risks are real, but the doom-and-gloom forecasts feel a bit overwrought.

MONEY

Higher Yields on Savings Accounts? It Will Be Awhile

The US Federal Reserve building is seen
The US Federal Reserve building is seen on August 9, 2011 in Washington, DC. New recession worries and market havoc posed the toughest challenge yet this year for the US Federal Reserve as its policy board met Tuesday holding a near-depleted box of stimulus tools. Economists said the Federal Open Market Committee (FOMC), meeting for the first time since its "QE2" asset purchase program ended in June, had few options to overcome stagnating growth and the growing pessimism that sent stock markets on their deepest plunge since the crisis of 2008. AFP PHOTO/KAREN BLEIER (Photo credit should read KAREN BLEIER/AFP/Getty Images) KAREN BLEIER—AFP/Getty Images

Waiting for higher yields on savings? Don’t hold your breath.

The Federal Reserve said in September it would buy $40 billion of mortgage-backed securities a month until the labor market rebounds. The goal: to free up banks to lend more.

It’s the Fed’s third attempt since 2008 to use this tactic, called quantitative easing.

Targeting the 8%-plus jobless rate, QE3, as it’s known, is likely to hold down mortgage rates which in October hit a 60-year low of 3.36%.

The Fed also plans to keep short-term rates near zero through mid-2015, so get used to current savings yields (recently averaging 0.12%).

And if you’re looking to beef up bond fund income, Morningstar Investment Management economist Francisco Torralba suggests short-term corporates, which yield about 2% today. Though the risk of inflation is low, he says, a spike would hit higher-yielding long-term bonds harder.

Related: Should I invest in bonds or in a bond mutual fund?

MONEY

Worried about the Fiscal Cliff: Should I Sell?

What changes do you think investors should make to their portfolios to avoid the financial meltdown that could result if we go over the “fiscal cliff”? — Mark Anderson, Lawrenceville, Ga.

If you’ve already set a reasonable investing strategy that reflects your risk tolerance and the length of time your money will be invested, then you probably shouldn’t be making any changes — at least not dramatic ones.

Granted, if we go over the fiscal cliff — that is, if tax increases and spending cuts kick in at the beginning of next year as currently scheduled — the economy could take a sizable hit. The Congressional Budget Office has warned that the unemployment rate could rise and the economy could slip into recession.

Should that happen, stock prices could go into tailspin. To avoid getting caught in the carnage, some advisers suggest that investors significantly cut back their stock holdings or move into more defensive shares that hold up better in downturns.

But I think this approach is wrong for a few reasons.

First, if you change course each time there’s the possibility of a setback in the market, you’re no longer staying true to an investing strategy.

You’ll just be reacting in a knee-jerk way to every potential threat that comes along. Indeed, if you had sprung into action every time investment managers and the financial press sounded the alarm, you would have rejiggered your portfolio many times over the past couple of years alone, responding to the U.S. debt ceiling imbroglio, Standard & Poor’s downgrading of U.S. Treasuries, the financial crises in Greece and Spain, not to mention the routine prognostications of doom that our fragile economic recovery could fizzle.

Related: Why There’s No Such Thing as Risk-Free Investing

More importantly, the idea that you should revise your investing strategy to protect yourself against some perceived calamity suggests that you know it will take place and how it will unfold.

That’s a big assumption. In the case of the fiscal cliff, for example, there are many possible scenarios that could play out, ranging from careening over the cliff to kicking the problem down the road to some sort of compromise on tax hikes and spending cuts.

Even if you could predict what will actually happen, you wouldn’t necessarily know what the fallout will be. No investment rises or falls in isolation. Stocks, bonds, Treasury bills, commodities, real estate, foreign securities — all are valued relative to one another as millions of investors globally make their individual buy-and-sell decisions. Predicting where prices will settle is a dicey business at best.

Finally, it’s not as if the fiscal cliff is some obscure issue no one’s aware of. It’s gotten tons of publicity. Which means that to some extent at least, asset values should already reflect investors’ concerns. Any moves you make are essentially trying to outguess the market consensus.

So as I see it, moving out of stocks into cash or bonds or making any other change specifically to protect yourself against the consequences of the looming fiscal cliff isn’t so much a rational choice as an emotional decision masquerading as a rational one. Any action you take could work out, or it may not.

Either way, you would then have to figure out what to do afterall the dust settles. Stick with the changes you made? Go back to your old stock-bond allocation? Shift to yet another portfolio mix based on some other potential threat or development? You’d be engaging in little more than an ongoing guessing game.

A better approach: Set an asset allocation strategy and stick to it regardless of whatever issue investors happen to be obsessing over at the moment.

Any money you’ll need to tap for emergencies or other purposes over the next couple of years should be in FDIC-insured accounts where it will be immediately available and immune to market downturns. You can divvy up the rest between stocks and bonds based on your risk tolerance and when you’ll have to tap into it.

Money you’re investing for a retirement that’s decades away you can afford to put mostly in stocks and shoot for higher gains, as you’ll have plenty of time to rebound from market setbacks. If you’re on the verge of retiring or already retired, you’ll want more of a buffer against market downturns, which argues for scaling back stocks and emphasizing bonds more.

The point, though, is that you should base your strategy not on shielding yourself from just any single risk like the fiscal cliff. Rather, you want to arrange your portfolio to provide adequate protection from the many different types of threats your portfolio may encounter, while still giving it a chance to grow.

One more thing: Aside from market concerns related to the fiscal cliff, there’s also the issue of whether investors should reap gains in their taxable accounts this year since the maximum tax rate on long-term capital gains is scheduled to increase next year from 15% to 20% — and in the case of very high-income investors, it’s supposed to rise as high as 23.8% due to a new Medicare surtax.

If you have long-term gains in investments you’re already thinking of selling — either as part of your regular rebalancing strategy or for other reasons — then carrying through on those plans before the end of the year makes sense. But I’d be wary of unloading investments with gains just because tax rates might go up, especially if you’re planning to hold those investments long-term.

Either way, don’t let any selling you do for tax purposes distort the balance and diversity of your portfolio. And if you plan on buying back any securities after selling them for a tax loss, be sure you don’t run afoul of the IRS’s wash-sale rules.

Bottom line: Until someone develops a crystal ball that will allow investors to truly foretell the future, you’re better off building a diversified portfolio of stocks, bonds and cash that can protect you from a variety of risks — and then resist the impulse to rebuild it every time a new worry comes along.

MONEY

Why There’s No Such Thing as Risk-Free Investing

What is the best no-risk way to invest my $500,000? — R.S., Las Vegas, Nevada

Sorry, but neither I nor anyone else can give you a no-risk way to invest $500,000, or any other sum.

All investing involves taking some form of risk, even if it’s not apparent. And while you may be able to sidestep one threat by choosing a particular type of investment, you will still leave yourself open to a different kind of danger.

Here’s an example. When investors say they want a low- or no-risk investment, they typically mean they want to protect the value of their principal and any interest or other investment earnings. Even if the economy and the markets go kerflooey, they want to know their account balance won’t drop.

That assurance is easy to get. Just put your $500,000 in FDIC-insured savings accounts. As long as you spread your money among several banks or otherwise take care that federal deposit insurance will fully cover principal and interest, you can rest easy. FDIC insurance is backed by the full faith and credit of the U.S. government after all. So unless you envision some sort of apocalypse that would force Uncle Sam to renege on his obligations, you don’t have to worry about losing a cent.

However, since bank accounts, Treasury bills and comparable cash-equivalents are so secure, they typically pay relatively modest returns. Their annual yields have been particularly low the past year or so, well below 1% on average. By keeping your dough in such accounts, you’re virtually guaranteeing you’ll earn a very low rate of return. And that leaves you vulnerable to other risks.

For example, if you’re still investing for a retirement that’s some years down the road, keeping your savings in low-yield investments could so stunt the long-term growth of your nest egg that you would have difficulty maintaining your standard of living in retirement.

Conversely, if you’re nearing or have already entered retirement and are counting on withdrawals from your $500,000 to pay living expenses, a meager return on your savings would force you to keep those withdrawals to a very modest level — say, an initial 2% to 3% of your portfolio’s value, or about $10,000 to $15,000, which you would then increase by the inflation rate each year to maintain purchasing power. Pull out more, and you would run a very high risk of running out of money early in retirement.

You can protect yourself against the risk of earning inadequate returns by investing your 500 grand in a diversified blend of stock and bond funds. There’s no guarantee, but over the long run you’re likely to earn several percentage points more a year than you would in bank accounts and similar “safe” investments.

For the 20 years to the beginning of this year, for example, stocks and bonds beat cash equivalents by 4.6 and 3.1 percentage points a year, respectively. So theodds are good that divvying up your money between stock and bond funds will leave you with a larger nest egg when you’re ready to retire — and allow you to draw more without running through your savings too early.

By owning stocks and bonds, however, you’re leaving yourself open to the danger that your savings will take a hit in the short-term. During the severe market downturn in 2008, for example, even a conservative portfolio of 50% stocks and 50% bonds would have lost 16%. Granted, such a portfolio would have recouped nearly all of that loss the next year. But for someone concerned about the security of his savings, a 16% drop could be pretty unnerving.

I could go on and on with other types of risk, but you get the idea. No investment can act as an impregnable shield that protects you from all possible harm.

Given that reality, how should you invest your $500,000?

Start by realizing that while you can’t totally eliminate all threats, you can at least gain some protection bytaking on several different risks simultaneously.

You’ll no doubt want to have money set aside in a secure place so it will be available in full no matter what happens in the market. But unless you plan on spending all your savings in the next few years, you don’t have to put it all in such a secure place.

So figure out how much you’ll need to tap over the next couple of years — $50,000, $100,000, whatever — and invest that amount in an FDIC-insured account. That way, you’ll have accessto the moneyyou’ll really need in the short term without subjecting the whole shebang to the prospect of anemic long-term returns.

Related: Should I Quit My Job and Travel?

Since you won’t need the rest of your dough immediately,you can afford to take more risk and shoot for higher returns. If you’re investing all or most of the remaining amount for retirement, you can divvy it up between stock and bond funds, depending on how far you are from retirement. If retirement is still a couple of decades or more away, you might want to invest, say, 70% or so in stock funds and 30% in bond funds. Such a mix will get whacked during market setbacks, but your savings will have plenty of time to bounce back.

If retirement is much closer or you’re already retired, stability is a higher priority, although you’ll still want some growth. So you may want to scale back your stock exposure to say, 50% or even less and keep the rest of your portfolio in bonds. This will give your nest egg more of a cushion should the stock market head south.

Bottom line: You can’t eliminate all risk when investing, and the more you focus on avoiding just one peril, the more vulnerable you’ll be to others. By diversifying smartly, you should be able to protect yourself adequately against a variety of risks, and lower the chances that any single threat will do your portfolio in.

MONEY

Contrarian Fund Bets on Europe – and Wins Big

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Tweedy Browne Global Value placed a big investing bet on troubled Europe. Photo: Thinkstock

There’s no secret to Tweedy Browne’s success. For decades this respected investment-management firm has sought out underappreciated stocks and held them until other investors eventually came around.

This explains why the four managers of the firm’s foreign-stock fund (who declined to be interviewed) are willing to keep far more assets in troubled Europe than their competition does.

Yet despite this, Global Value TWEEDY BROWNE FUND GLOBAL VALUE FUND TBGVX -0.2523% has generated annual returns of 12% for the past three years, vs. less than 4% for the MSCI EAFE index of foreign shares.

A big bet on Europe

How has Global Value beaten 98% of its peers over the past five years while investing so much in recession-racked Europe?

First, it has largely stayed away from the region’s worst debtors, the PIIGS: Portugal, Italy, Ireland, Greece, and Spain. Its biggest stakes are in Switzerland, the U.K., and the Netherlands.

The fund also favors multinationals with emerging-market ties.

Last year nearly a quarter of sales of top holding Nestlé came from fast-growing Asia Pacific and Africa. And the fund tilts toward defensive consumer stocks, led by recession-proof brewer Heineken. Consumer staples make up 31% of the fund, vs. 10% for its peers.

Of course, says Todd Rosenbluth, an analyst at S&P Capital IQ, “it’s a risk if consumer staples begin to lag.”

As the dollar goes …

Tweedy Browne plays defense in other ways. The managers are holding nearly 15% of assets in cash. When they buy foreign currencies to invest abroad, they offset that through forward currency contracts that effectively expose the fund to an equivalent amount in dollars.

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With the buck thriving lately, this strategy has bolstered returns.

Over the past three decades, though, the dollar has fallen more than it has risen, which has been a drag on the portfolio at times. The firm launched a version of the fund that doesn’t hedge. But by going unhedged, you’d be exposing yourself to currency risk, says Morningstar analyst Kevin McDevitt. You’d also be betting even more on Europe, since that fund would benefit if the euro rebounds.

Lower highs, higher lows

This fund, which has ranked in the top 1% of its peers during the past 15 years, may seem like a no-brainer.

But Lipper analyst Tom Roseen notes that Global Value’s annual fees of 1.4% are “only mediocre” within its category. (The average, in fact, is 1.4%.) And though Global Value has thrived over the long run, there have been shorter periods when it has lagged.

Analysts liken Tweedy Browne’s approach to that of Warren Buffett’s. Both search for deeply undervalued stocks that may be overlooked for years. Sounds great, but when the markets sizzle, Global Value — like Buffett — can underperform. Between March and December 2003, for instance, when foreign stocks soared nearly 49%, Global Value trailed by 14 percentage points.

MONEY Ask the Expert

The Case for Investing in Bonds, Too

Q. I’m 52 and have had 100% of my savings in stocks since I began investing at age 25. Given my high risk tolerance and the fact that I expect that my pension and Social Security to cover a substantial portion of my expenses in retirement, why should I reduce my investment returns by investing in bonds? — Eric C.

A. If you’ve been putting your dough exclusively in stocks for the past 27 years, then you know firsthand how lucrative they can be over the long term. Since 1985, the year you began investing, stocks have gained an annualized 11%.

You no doubt also know how risky stocks can be over shorter periods. You’ve lived through the Crash of 1987 when the Dow Jones Industrial Average plummeted 508 points — nearly 23% — in a single day. And you’ve survived both the bear market of 2000-2002, which saw stock prices fall 49%, and the meltdown of 2007-2009, when stock values dropped almost 57% (a setback from which they still haven’t fully recovered).

I’m sure I also don’t have to tell you that bonds returned far less than stocks over the past 27 years and that their yields are especially low right now, with 10-year Treasury bonds yielding less than 2% and investment grade corporates paying only a half percentage point or so more.

Given your experience with stocks and the state of the bond market these days, I can understand why you equate keeping any of your savings in bonds as nothing more than an invitation to subpar returns.

But I think you need to revise your thinking. Here’s why:

You became an investor near the beginning of one of the greatest bull markets in history. The surge in stock prices that began in 1982 and with few interruptions continued through the end of 1999, showered investors with almost unprecedented rewards. It also included some truly phenomenal stretches, like the 10-year span from 1989 through 1998 when stocks gained a compounded 19% a year, almost double equities’ long-term annualized return since 1926. So I think it’s fair to say that this outsize performance has a lot to do with the way you feel about stocks.

Related: Investing: When to ‘Take Money off the Table’

What’s more, up to now you’ve viewed the risks and rewards of stock investing primarily through the lens of a relatively young person. Which means you’ve been much more likely to shrug off stocks’ periodic setbacks. They’re not as scary when you have decades to rebound from them.

But looking ahead, conditions may be quite different. While stocks are still likely to beat bonds over very long stretches, many analysts believe stocks won’t deliver anywhere near the same size gains they did in the go-go ’80s and ’90s, nor will they outperform bonds by as large a margin.

That’s certainly been true for the past 10 years with stocks gaining 7.3% vs. 6.3% for bonds. Some investment advisers, like PIMCO’s William Gross, are even forecasting extremely meager stock returns for the years ahead.

And while you may still think of yourself as quite the risk taker, I think you should allow for at least the possibility that a 50% decline in the value of your savings — and the retirement income it might produce — may be much more upsetting as you get closer to the end of your career than it was when you were starting out. I’m a bit older than you, but I’ve found I’m much more sensitive to stocks’ volatility myself.

As you weigh the issue of risk, you may also want to factor into your thinking recent research that suggests that the severity of downdrafts we’ve seen in stocks in the past may occur more frequently than we previously believed.

At any rate, I recommend that you at least consider scaling back your equity exposure. I’m not talking about a total retreat. Rather, I’m suggesting a stocks-bonds mix that allows for long-term growth, but won’t get hammered as much should the market tank during your home stretch to retirement — say, 70% stocks and 30% bonds. As you age, you would then gradually reduce your stock stake, dialing it back to 50% or so of your holdings by the time you retire and then eventually paring it down to between 20% and 30%.

If you expect that your pension and Social Security will cover most of your basic retirement living expenses, you’ll have more leeway in how much you’ll have to draw from your stock portfolio. That flexibility could allow you to be more aggressive and increase your stock percentage a bit. But I’d be wary of going higher than, say, 75% to 80% stocks today and 55% to 60% at retirement.

Related: Retirement Income: Five Steps to a Sound Plan

Many investors are particularly wary of making bonds part of their portfolio these days for fear they could suffer losses if interest rates rise. But the potential setbacks in bonds — especially those with short- to intermediate-term maturities — pale in comparison to the hits stocks have taken in the past and could take in the future. So despite any anxiety about interest rates rising, bonds are still a worthwhile way to reduce the overall risk level of a portfolio.

Bottom line: I’m all for maintaining reasonable exposure to stocks in the years leading up to and following retirement. But the key word is reasonable. Obviously, you have to decide what’s appropriate for you. But you’ll be a lot better off if your decision includes a realistic reassessment of your risk tolerance rather than simply going with what worked over the past 27 years.

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