The most important investment decision you'll make this decade

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Janet Yellen doesn't think much of stocks. Should you?

Especially if you're over 50, your answer to that question may be the most important investment decision you make this decade. To help you along, the chief of the U.S. Federal Reserve has offered up a surprisingly blunt assessment.

Ms. Yellen told a conference last week that stocks "generally are quite high" and added "there are potential dangers." Her message to investors was clear: These are treacherous waters. Swim at your own risk.

Younger investors can choose to ignore the warning. After all, their portfolios have time to recover if markets turn choppy. But those who are nearing retirement, or are already retired, don't have that luxury. A market storm could wash away the savings they are counting on.

The problem is knowing where to go if you do decide to seek safety. Bonds now offer next to no return, especially after inflation. They also carry their own dangers. Since bond prices fall as yields rise, any move up in today's historically low interest rates would hammer bond values.

Financial experts are divided on the best plan. Before making your own decision, spend a moment to understand the logic behind their often conflicting advice.

Stay the course

Many advisers recommend sticking to a standard balanced portfolio of stocks and bonds during retirement, but gradually reducing the risk level as you get older by cutting back on stocks in favour of more bonds.

Adrian Mastracci, a fee-only portfolio manager at KCM Wealth Management in Vancouver, says today's bond yields are so low that many retirees have no choice but to keep a significant part of their portfolio in stocks, especially at the beginning of their retirement, to generate some growth.

Depending on personal priorities, most investors feel comfortable with anywhere from 40 per cent to 60 per cent stocks. But as an investor grows older, and puts more emphasis on preserving what she already has, the stock exposure might dwindle to a more conservative 20 per cent.

After all, "if you're wrong about your asset allocation, and something bad happens, you're probably not going to want to go back to work at the age of 75 to set things right," Mr. Mastracci says.

Take a contrarian stance

A new school of thought recommends that retirees take precisely the opposite approach. This strategy suggests starting with little exposure to stocks, then ratcheting up that exposure as you age.

The logic here is that you are most vulnerable to a market collapse in the handful of years just after you retire, when you first start depending on your portfolio for income.

If stocks plunge at that point, and you have a hefty stock allocation, the fall will wipe out a big portion of your savings – and then your regular withdrawals will keep on draining your funds. The combination of the initial hit, plus your income needs, can exhaust your money surprisingly fast.

Loading up on bonds early in retirement prevents such a calamity. If the stock market crashes during the first crucial years of retirement, you barely feel it.

Then, as you spend down the bond portion of your portfolio, over the course of several years, stocks come to make up a larger and larger portion of your portfolio. While this may increase risk, it also increases potential growth – an important consideration for those with long lifespans.

This "rising equity glidepath" notion was suggested in 2013 by Wade Pfau, a professor at American College in Philadelphia, and Michael Kitces, director of research for Pinnacle Advisory Group in Columbia, Md.

Their concept has since generated much controversy, but the two researchers say it's actually less radical than it may appear. For a typical retiree, it means starting with 30 per cent equities and seeing that rise over a couple of decades to 60 per cent – a level that is no riskier than a conventional balanced portfolio.

In many ways, the rising equity glidepath resembles the bucket strategy recommended by many financial planners. In this approach, retirees split up their money among cash, bonds and stocks.

If stocks tumble, the retiree first spends the cash bucket, then the bond bucket. By the time he reaches the stock bucket, the market will likely have recovered much of its losses – or so the theory goes.

Of course, the reality is that no one knows exactly what the market will do. But retirees and near retirees should think through which approach they feel most comfortable with – a bucket strategy, a rising equity glidepath or the traditional move toward bonds. If Ms. Yellen is right, we all need to be braced for trouble.