01/19/2012 10:43 am ET Updated Mar 20, 2012

How to Retire Without Worrying About Social Security

It's probably the most important retirement question you can ask. But, unfortunately for you and for financial advisers, there's no right way to answer it. How should I allocate my assets?

Your decision may mean the difference between relaxing on that yacht or chasing the mailman for your social security check.

Asset Allocation 101

Simply stated, asset allocation means diversifying your investments. It's best expressed by the adage "don't put all your eggs in one basket." Investing in just one type of security -- be it high-yield stocks or government bonds -- subjects your portfolio to potentially devastating market fluctuations. A study by Brinson, Hood and Beebower found that asset allocation causes over 90 percent of volatility in an investor's returns.

According to The Four Pillars of Investing, by William Bernstein, during the 1973-1974 bear market, investors who only held stocks found themselves down over 40 percent. But, investors who diversified by holding 25 percent stocks and 75 percent bonds lost less than 1 percent of their net worth.

Still, asset allocation is more than just owning both stocks and bonds. How much you hold of each asset is just as important as the assets themselves.

Guidelines to Proper Asset Allocation

How to effectively allocate your assets for future market performance is, however, a matter of personal preference and perception. The decision is based on factors like: 1) how much investing knowledge you have, 2) how long you think you might live and 3) how much of a legacy your hope to leave to your family. Each decision will influence your investing strategy.

While there are no hard and fast rules to effective asset allocation, here are some guidelines to a stress-free retirement:

1. Balance risk with reward.

A successful portfolio does just that. Fixed income tends to be more secure, but equities tend to return more over the long-term. In general, based on historical statistics, you can expect equities to return an average of 10 percent annually, fixed income to return 5 percent yearly and cash or equivalents to return 3 percent over the long-term.

The first step to appropriate asset allocation is to decide how much you want to allocate to lower risk, lower return fixed income instruments (such as bonds and preferred stock) and how much capital you want to put toward higher risk, higher return equities.

In addition to stocks and bonds, your investment choices might also include money market funds, gold and silver, and insurance products, like annuities.

2. Find the right mix.

There's no set rule for how you should allocate your assets, but a conventional guideline is 100 minus your age. Take 100 minus your age as the percentage you should hold in stocks; the balance should be in fixed income. For example, if you're currently 65, you'll want to keep 35 percent in stocks (100-65=35) and 65 percent in bonds (100-35=65).

3. Adjust as you age.
As long as you don't live beyond age 100, the above formula will suit you fine. But maybe you're a regular runner on a macrobiotic diet -- or you've been blessed with great genes. In that case, there are arguments the calculation should be increased to 110 or 120 minus your age. At 120 minus age 65, you'll want to keep 55 percent in stocks (120-65=55 percent) and the remaining 45 percent in fixed income. Notice how the allocation of stocks to fixed income increases the longer your expected lifespan. If you think that formula is too general, you can try an online calculator, like this one from Forbes.

4. Have enough capital.

The key to a financially comfortable retirement is to have your assets outlive you. A good target is to have enough capital to comfortably withdraw an average of 4 percent annually for the rest of your (and your spouse's) life. This 4 percent withdrawal guideline is based on an average portfolio growth rate of 7 percent, minus an average 3 percent inflation rate. Additionally, you'll want the income from your investments to supplement any pension and old-age income you might receive.

5. Protect yourself from inflation.

Inflation is an important factor to consider in retirement planning. Over the last century, inflation has occurred at an average clip of about 3.4 percent, annually. Think about how factors such as your age and your current level of capital might be affected by future inflation. Plan accordingly. For example, you might want to allocate at least 10 percent of your investment portfolio to gold. Historically, gold has held or increased its value during high inflation periods.

The Investing Answer: Asset allocation can be daunting. But, taking the time to plan and design an ideal portfolio is worth its trouble in gold. Consider you age, your risk tolerance and your income needs. Then decide on the investments that are best suited for you. A well planned allocation strategy may allow you to achieve even the most optimistic retirement dreams.

By Deborah O'Malley, M.Sc. and Melvin Pasternak, Ph.D.,