My colleagues Lisa Lewitzke, Diana Sarandos and I recently had the opportunity to provide our outlook on the markets and economy to a group of interested clients and friends at the Racine Marriott. In addition to our current investment insights, we provided a segment on retirement planning. The time allotted was sufficient only to provide a brief overview of our thinking. But that alone got me thinking that it was time to put more "retirement insights" into one of our columns. Recent market turbulence makes these thoughts all the more timely.

Defining objectives

Regardless of one's investment experience, the first step in developing a portfolio is to determine the objective for the investments you will be making. Establishing appropriate objectives will keep you on the path toward the achievement of those objectives, despite temptations that might otherwise cause you to stray. For purposes of this article, I am assuming that we are retired investors with one simple goal: we are attempting to enhance our lifestyle in retirement by investing in a portfolio of assets that will provide us with an appropriate amount of income for the rest of our lives.

Ascertaining your tolerance for risk

Because we will be selecting from investment vehicles that present different "risk" or "volatility" characteristics, it is important for us to ascertain our "risk tolerance" or "comfort zone" of investing. The best analogy I can draw to this exercise is the process of selecting a car. Another might be choosing rides at an amusement park. Some individuals can tolerate the thrills, spills and excitement provided by sports cars and roller coasters. Others would be sickened by either experience. When it comes to investing for retirement, you must have a portfolio that you can continue to hold regardless of what obstacles, twists and turns you may encounter.

Different vehicles for different purposes

Turning now to the specific types of investments that are analogous to sports cars and roller coasters, I will suggest that sector specific funds (technology, real estate, etc.), aggressive individual stocks (Citigroup, AIG , etc.), and Emerging Markets funds are not the type of thing one should choose if the avoidance of risk is any sort of priority. Likewise, some of the biggest mistakes I see investors make involve focusing on the distributions, "yield," or "past performance" of a particular investment. In contrast, some investors focus too much on yield, thereby neglecting what is causing it and overlook the importance of having something in a portfolio that will cause it to increase in value over time. Although some investors completely avoid risk because of having experienced a loss of principal in the past, having a portfolio that is "too safe" can significantly reduce one's standard of living in retirement.

For the purposes of this exercise, I will assume that the tools we will have to use for the construction of our portfolio are relatively simple: we can use money markets and CD's, bonds, stock and bond funds, international or global funds and balanced funds. We can put them together in any fashion that we think will cause us to accomplish the objective of providing a reasonable level of income, for life.

Putting it all together

In preparation for this article, I developed a series of models to test how different types of investment portfolios would have performed over the past five years. I will note that I was surprised that all of the scenarios tested provided positive returns despite the stock market's roller-coaster performance over these five years. However, in each case the 5 percent draw rate, increasing annually for assumed inflation at 3 percent, eroded investment principal. This should be taken with a grain of salt. Five years is not a long time in the investment universe. Given how bad this past five years was, it is significant as an example of how well designed portfolios can endure even the worst of investment storms. It is reasonable and appropriate to assume that the markets will be significantly better for investors over the next five to 10 years.

These examples are intended to give you at least the vicarious experience of different types of portfolios as they traveled through the recent past. What none of us can do, however, is to predict the future. This is where risk tolerance comes in. If you know you have a low threshold for investment losses, you have to be more conservative. If you know you can withstand the temptation to leave your investment path when the road becomes difficult, you can take on more risk.

The most conservative example I can give is of the retiree who wants no investment risk at all. In short, this is the retiree who will leave their money in the bank or invest in CDs. In today's marketplace, this investor can expect to earn in the neighborhood of 1 to 3 percent. By assuming, hypothetically, that an individual retired in October 2004, with a portfolio of $300,000 and requiring a distribution level of 5 percent with a 3 percent inflation adjustment each year we can compare this "safe" alternative to others.

In this safest of examples the investor started by spending $15,000 per year. He or she now is spending almost $17,000 to keep up with inflation. Because the portfolio's returns have fallen short of the retiree's spending needs, the $300,000 portfolio is now down to $262,000 and the distribution as a percentage of the principal has risen to 6½ percent.

Had this investor invested in a quality bond fund and taken the same distributions, he would have fared worse as the portfolio would now be worth $249,000 and the distribution rate would now be almost 7 percent.

Taking slightly more risk and investing in a representative "balanced mutual fund," containing a conservative mix of stocks and bonds, the retiree would now have $245,000 and has also seen his or her distribution rate, expressed as a percentage of the portfolio value, rise to about 7 percent.

Not being satisfied with the simplistic approach of using a representative "balanced" fund to accomplish our income objective, I designed a portfolio of ten funds of various types that would expose my hypothetical investor to a moderate mix of less than 50% in stocks, about 35 percent in bonds and about 15 percent in cash. This "customized portfolio" was the best performer of all I tested, outperforming all of the perceived "safer" alternatives.

Because the retiree's draws exceeded the returns achieved over this time period, this investor now would still have less than he or she started with, approximately $272,000, and a new distribution rate of just over 6 percent.

Advice today

Although a perfectly safe cash and CD portfolio will provide income without risk of principal, it will invariably fall short of meeting most investors' needs for an increasing level of income.

Bonds, despite concerns today about higher interest rates, have proven to be an excellent vehicle for providing a reasonable level of income without excessive risk to principal. Bonds and bond funds should be carefully chosen and diversified by quality, duration, yield and jurisdiction with municipal bonds being an outstanding tool for high income investors.

Stocks individually present risks that can be modified and crafted by the use of mutual funds. Although they are an important part of one's retirement portfolio, they should not be abused. The S&P example above demonstrates the damage that can be done by taking too much risk just before an unanticipated market storm.

Arthur S. Rothschild, J.D., CPA, CFP is a vice president of Landaas & Co. Investment Services. Your comments or suggestions for future articles are welcome at (800) 236-1096 or by email to arothschild@landaas.com