A step-by-step guide to asset allocation in retirement

The best asset allocation strategy for retirees isn't a one-size-fits-all formula. There are several variables that determine your ideal stock/bond/cash allocation, such as your age, risk tolerance, and more. Here's a quick guide to help you determine the optimal allocation for your 401(k), IRA, and other retirement accounts.

1. Learn the basic concepts of asset allocation

Asset allocation refers to how much of your investment portfolio should be invested in stocks (equities), bonds (fixed-income), or cash-based assets.

The general idea behind asset allocation is that stocks offer the best long-term growth potential, but can be quite volatile over short time periods. On the other hand, bond investments can be excellent tools for preserving your capital, but offer relatively limited return potential. Finally, cash assets are risk-free, but also earn very little returns.

As we'll see, asset allocation is about finding the appropriate mix of risk and return potential for you.

2. Using your age, approximate your ideal stock/bond mix

Notice that I didn't say stock/bond/cash mix. Even in retirement, I generally discourage people to keep more money in cash than they need for their near-future living expenses. I'm of the opinion that all of your savings should be earning something, and there are bonds that aren't much riskier than cash (short-term Treasuries for example) but pay significantly more than most savings accounts.

With that in mind, here's a good rule of thumb to estimate your ideal asset allocation. Simply take your current age and subtract it from 110 to find the percentage of your assets that should be allocated to stocks, with the remainder invested in fixed-income assets. For example, if you're 70, this implies that about 40% of your investment assets should be based on equity and 60% on fixed-income investments.

3. Evaluate your own risk tolerance

Could you deal with your portfolio dropping by 50%? The stock market has done that before, and may eventually do so again, so as a rule, don't invest any money in stocks if you wouldn't be comfortable with it being subjected to this kind of volatility. However, the fixed-income portion of your portfolio can help to offset (but not eliminate) this risk during tough times.

To be clear, all investing involves risk, and markets will fluctuate. The point is that your portfolio should be designed to keep your volatility at a relatively low level for the amount of income and growth you hope to achieve.

Therefore, the next step is to evaluate your own risk tolerance. Using your age-based allocation from step two, adjust accordingly if you feel that you have a higher or lower risk tolerance than other investors in your age group. As an example, if you have a relatively large Social Security benefit and some pension income coming in, you may be comfortable taking on a little more risk with your investments since more of your day-to-day income needs are met.

4. Choose your investments

It's important to understand that not all stock investments carry the same level of risk. For example, a small-cap growth stock fund or an emerging-market fund will likely be more volatile than a broad large-cap index fund. Having said that, retirees should typically stick with lower-volatility stock investments.

To give you an example of what I mean, one of my personal favorites for retirees is the Vanguard High Dividend Yield ETF (NYSEMKT: VYM), which invests in large companies that pay above-average dividends. I love this fund for older investors for a few reasons:

• It provides a strong, reliable income stream (yield of about 3%).
• High-dividend stocks tend to be more mature, stable companies, and are therefore less volatile, as a whole.
• Dividend stocks tend to do better than their non-dividend counterparts during tough times.

The same can be said for fixed-income, or bond, investments. A one-year Treasury and a high-yield corporate bond aren't even in the same risk category.

My point in this step is that you can also adjust your risk level by selecting investments that fit your risk tolerance, not just by changing your stock/bond allocation. As a bond-related example, I often suggest the Vanguard Total Bond Market ETF (NYSEMKT: BND) for most investors' bond needs, as it has broad exposure to investment-grade bonds of various maturities. On the other hand, an older investor with low risk tolerance might be better off with the lower-volatility but lower-paying Vanguard Short-Term Bond ETF (NYSEMKT: BSV). Here are a few other examples to consider.

5. Do your homework

My final point is that your asset allocation in retirement isn't just something you do once. Rather, it's important to reevaluate your asset allocation periodically throughout your retirement, especially if a major life change occurs.

Think of it this way – if you retire at 65, your nest egg should last you several decades, so although you may be drawing income from your investments, growth is still a priority. On the other hand, when you're 80, growth becomes less of a priority and capital preservation and income become more of the primary focus.

In addition, as time goes on, your allocations can become distorted due to the performance of your investments, especially if your stock investments have done particularly well (or poorly). For these reasons, it's a smart idea to reevaluate your portfolio and make changes accordingly every few years.

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Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.