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Retirees: 6 Takeaways From the Recent Market Drop

Those in retirement should keep these tips in mind for positioning their bond and equity portfolios.

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A bear market might be good news for young investors looking to buy stocks on the cheap, but budget-priced stocks are thin gruel for retirees and pre-retirees who are relying on their portfolios to fund living expenses. A deep and protracted down market, such as the one we encountered in 2008 through early 2009, can translate into a meaningful reduction in a retiree's quality of life, particularly if that retiree hadn't steered enough of her assets to relatively safe securities like cash and bonds.

The most recent market action, while not as violent or scary as the bear market that coincided with the financial crisis, nonetheless carries some takeaways for retired investors or those looking to hang up the workaday life within the next few years. Below I highlight a few.

1. Get Used to Low Yields (as if You Weren't Already)
Don't like the rock-bottom yields that you're earning on your cash? Unfortunately, there's no relief in sight. True, some market watchers (myself included) had been warning about the potential for higher interest rates at some point in the not-too-distant future. But that eventuality became even more distant on Tuesday, when the Federal Reserve announced that it will hold interest rates near zero through the middle of 2013. That's good news for borrowers and owners of riskier assets, such as stocks, but it's bad news for yield-starved savers.

Although there's no substitute for true cash if you need to have money ready for near-term expenses, the currently inhospitable environment argues for a couple of tactics on retirees' part. First, don't hold more cash than you need to fund one to two years' worth of living expenses (expenses not covered by other sources of income, such as Social Security), as the opportunity cost of holding too much cash is extreme. Second, don't put up with nonexistent yields from your local bank; shop around and be willing to be flexible. This video discusses some ideas for wringing more income from your cash, and this article discusses how to create a two-part short-term fund consisting of true cash combined with a high-quality short-term bond fund.

2. Don't Be Too Quick to Cast Out Treasuries
In recent months there's been a lot of trash-talking going on in the Treasury market. Some investors have been avoiding the bonds or even shorting them, saying the bonds' yields are too low and the U.S. deficit is too high. There is also fear that Treasuries will get creamed in a rising-rate environment. And, in the latest bit of ignominy for Treasuries, Standard & Poor's said they can no longer be considered a "risk-free asset."

But the market's recent swoon telegraphed something loud and clear: In a true flight to safety, very few assets will hold up better than U.S. Treasury debt, downgrade or not. That's not to say Treasuries are a screaming buy at this point, and yields are more anemic than ever. But it does argue for not getting too heroic about purging them from your portfolio altogether. If your goal is to find an investment that will zig when your stocks are zagging, it's hard to argue that Treasuries don't deliver.

3. Handle Junky Bonds With Care
On the flip side, not all bonds have behaved well during the recent stock market swoon: High-yield bonds and bank-loan investments have posted losses, in large part because of their sensitivity to the economic cycle. When investors are feeling good about the economy's prospects, it's off to the races for the highly leveraged companies; if these firms' businesses are booming, investors feel good about their ability to make good on their debts. But the reverse can happen when recessionary worries roil the market, as has been the case recently. Bank-loan and high-yield funds haven't posted calamitous losses, but their recent weakness is a wake-up call about not using such investments as an antidote to your stock holdings. When stocks are down, bank-loan and junk bond funds will tend to move in the same direction, as I argued in this article.

4. A Well-Thought-Out Asset Allocation Is Your Best Friend
I didn't put this point first because I wanted to hold your interest; I was afraid that you might read it and think "there she goes again." But really, this is my most important point. If you're retired or getting close, by far the best way to ride out periods of market weakness is to pay due attention to your asset allocation and cash reserves. If you have enough invested in the safe stuff to cover your income needs for the next several years, you can ride out weak stock market periods, both psychologically and logistically. The bucket approach to staging retirement portfolios, whereby you stash enough to cover your near-term expenses in ultrasafe securities and hold the rest in long-term securities like bonds and stocks, is an intuitive way to back into the right appropriate asset allocation.

5. Make Sure at Least Some of Your Stocks Are Playing Defense
Because the recent sell-off was fueled by fears of global economic malaise, any stocks that were perceived to be economically sensitive took it on the chin: namely, industrials, basic materials, retailers, financials, and energy. At the other end of the spectrum, stocks with defensive characteristics performed well, including consumer staples and pharmaceutical stocks. The takeaway isn't that you should purge economically sensitive names from your portfolio; holding both defensive and more cyclically oriented companies will help ensure that at least something in your portfolio is performing well no matter the stage of the economic cycle. But if you're retired, I think it's perfectly fine to consider shading your equity assets toward defensive names, not just now but always. Such stocks have lower volatility than more cyclical firms; they're also more likely than economically sensitive companies to have economic moats, or sustainable competitive advantages. Solid mutual funds with big shares of their portfolios in defensive stocks include  Vanguard Dividend Growth (VDIGX),  Yacktman (YACKX), and  Dreyfus Appreciation (DGAGX).

6. Dollar-Cost-Average Into Inflation Protection
Amid concerns over slowing economic growth, the inflationary worries that were in the forefront of investors' minds just a few weeks ago have been back-burnered, at least for now. True, Treasury Inflation-Protected Securities' prices have stayed up (they're Treasuries, after all) and commodities have also fared reasonably well. But if gloom over the strength of the global economy continues to worsen, inflation-conscious investors might be able to add inflation protection to their portfolios at more advantageous prices than when inflation was grabbing all the headlines. Dollar-cost averaging into such investments will help reduce the odds of buying into inflation fighters when their prices are lofty.

See More Articles by Christine Benz

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Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.