Obviously, we can't tell you everything about asset allocation strategy here in the free section. But we can give you a pretty clear idea about what's inside if you subscribe to Retired Investor.
Let's start with some basic principles. First, every investor faces the challenge of balancing downside protection (against capital loss) with upside potential (for high returns). Second, research has shown that in general, people are more sensitive to losses than they are to gains of the same magnitude. Third, the degree of mismatch between your current savings and your financial goals tends in practice to create situations where the amount of downside protection you want is less than the amount you can afford (in terms of foregone returns on higher risk assets). In other words, there is usually a tradeoff between your lifestyle, your financial goals, and your asset allocation. As with so many other things in life, there is no free lunch here either!
Different asset classes provide different degrees of downside protection and upside potential. Broadly speaking, our "home market" (we think of this as the market in which returns are denominated in the same currency as our liabilities) can be in one of three states: normal, high inflation, or deflation. In the normal state, we don't need as much downside protection as we do in the other states, and look to equity type investments to generate high returns for us. In the inflationary state, we look to asset classes like real return bonds and commodities (and possibly foreign bonds and real estate, but more on that in the Members Section, to protect the purchasing power of our capital. In the deflationary state, we look to investment grade bonds to preserve our capital while maximizing our real returns.
Finally, in deciding on your asset allocation, you need to keep in mind the critical distinction between "yield" and "total return." The former refers to the amount of income you expect to receive from an asset, divided by the price you pay for it. For a bond, it is the coupon interest it promises to pay. For a stock, it is the current dividend (which, don't forget, the company can change at any time). In contrast, "total return" refers to the yield you return over a given period, plus the change in the price of the asset over the same period. For example, when market interest rates rise, the price of a bond usually declines (and when market rates fall, bond prices usually rise). Equity prices react in much the same way to interest rate changes, but are also affected by many other economy-wide and company-specific factors.
Why is this important? Because too many retired investors focus on high yields, and ignore total returns, which sometimes gets them into serious trouble. The root cause of this error is the belief that the best way to avoid outliving one's assets is to avoid "spending one's capital." This policy leads people to seek high yielding investments to provide the income they seek without "spending their capital." As we have noted, this rule of thumb is at odds with economic logic, which suggests that the best way to avoid outliving one's assets is to use a prudent mix of annuities and careful asset allocation policy. More important, people who seek high yields too often actually end up destroying the value of their capital. For example, a high yield on a bond usually indicates relatively poor underlying credit quality -- that is, a high risk of default. Similarly, a stock can carry a high dividend yield because its price has been falling rapidly as its business weakens. Under these circumstances, dividend cuts often follow, leaving the investor with less income than he or she expected, as well as capital that is much reduced in value.
We cannot say this too often, or too strongly: prudent retired investors focus on the total return of their portfolio, not simply on investments that promise high yields.
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As we have noted, once you have decided on your target asset allocation, you face another big decision: do you implement it through actively managed funds or through index funds? For more discussion on this point proceed to Actively Managed or Index Funds.