4. You can't avoid risk by avoiding stock market
Like everything else in life, investing involves trade-offs. With stocks, you lose money when the market falls. But thinking only about that risk is like looking only one way when you cross the street.
Look the other way and you'll see that with bonds, you risk losing purchasing power to inflation. (In case you've forgotten, in January 2003 a dozen eggs cost $1.17, a pound of ground chuck cost $2.13 and gasoline cost $1.55 a gallon. This January, the eggs cost $1.93, the meat cost $3.40 a pound and gasoline sold for $3.41 a gallon.)
The best solution: Divide your money between stock and bond investments. You need stocks because they can grow your money enough to keep pace with the cost of living. A healthy 65-year-old man today can expect to live into his 80s, and a healthy 65-year-old woman into her 90s.
"Many 65-year-olds should keep at least 50 percent of their portfolios in stocks," says Harold Evensky, a Coral Gables, Fla., financial planner. You need bonds because they can put a floor under your stock market losses, says Christine Benz, Morningstar's director of personal finance. If you invest in both, you'll still lose money in a market meltdown — but you won't lose as much, and you'll recover faster.
An example: If you invested $10,000 in the Vanguard S&P 500 Index Fund at the 2007 market peak, at the market bottom your account was worth $4,474. If you invested half your money in the Vanguard Total Bond Index Fund, at the end of the bear market your $10,000 was $7,600. By the end of February 2013, the 50-50 investment was worth $12,253; the 100 percent stock investment was worth $10,858.
Today, the safest bonds — short-term bonds with high credit quality — pay almost nothing. Many investors are abandoning them in favor of riskier high-yielding bonds. That's a mistake, says Benz. "Lower-quality bonds and emerging market bonds pay more, but they won't insulate you from stock market shocks." Think of short-term bonds' low returns as the price you're paying for insurance.