In the wake of the 2000-2001 bear market, you may want your portfolio to become more conservative as you grow older, with more emphasis on bonds and cash to add income as well as stability. If so, you should begin changing your portfolio when you’re two years away from retirement. At this stage of your life, you may not be able to tolerate sharp declines in asset values, and those declines are more likely to occur in stocks.
Suppose, for example, you had an 80-20 asset allocation, heavily skewed towards stocks, for long-term growth. In the two years before retirement, you might gradually move towards a 50-50 allocation. A portfolio evenly divided between stocks and bonds has less risk of a large loss of principal.
In addition to more bonds, as a pre-retiree you should hold more cash. During your working years, you might want to hold six months’ worth of spending money in cash reserves in case of an emergency. As you approach retirement, you should increase your cash position to a year or even two years’ worth of spending. Then, in case of a bear market, you can tap your cash reserves for spending while maintaining your equity allocation. You won’t be forced to sell while the market is low.
Eventually, when your cash reserves run out and they have to be replenished, you should refill your cash position from whatever investments have done better recently. For example, in 1999 and early 2000 you would have done well selling off high-priced technology stocks to raise spending cash. Now, turning investments into cash might mean selling the value stocks, the small-cap stocks, and the bonds that have been the top performers since then.
