Why should investors pick less risky investments as they approach retirement?
Investors must decide for themselves what the term "risky investment" means to them. At age 25, you may feel comfortable dabbling in investments that have the potential to earn returns between +50% and -30% in one year's time. However, by about age 60, your comfort level may shift to a more practical level of +12% to -8% over a year's time.
When people are gainfully employed, they have the earning power to make up investment losses that their portfolio may suffer due to poor market performance or bad judgment calls. As workers approach the five-year retirement mark, they tend to scale back asset allocation to more conservative positions to keep pace with their diminished earning power. Such measures could prevent investment losses, which have the potential to disrupt portfolio growth and delay retirement.
During the golden years of retirement, many seniors live on fixed incomes derived from social security benefits or pensions. Because of reduced earning capacity, most seniors cannot afford to suffer devastating losses from risky investments. Simply put, they have no way to replace lost funds. Asset allocation explains more than 90% of volatility on overall portfolio returns and, therefore, should be considered carefully.
When we think of "risky" investments, equities, or stocks, come to mind. When we think of "conservative" investments, fixed income products such as bonds, CDs and money market accounts are referenced. For investors in their 20s and 30s, a common asset allocation might be comprised of 80% equities and 20% fixed income. As investors approach or enter retirement, it is more common to see the allocation shift to more conservative levels of 60% equities and 40% fixed income - or maybe even 50/50.
This question was answered by Steven Merkel.