I am retired with a small nest egg and have very little income. Because I must live off this nest egg, it is important that my investments generate adequate income. But this income is not likely to be adequate, so my investments must also provide growth. How should I proceed?

Paul's Answer:

I can't give you a specific answer without more information. How much do you have in your nest egg? How much income do you need? How much additional income do you assume you will need in the future? How long will you need this income? Are you willing to deplete your funds by the end of some assumed period (for instance age 95) or do you want or need to maintain your assets after your death? All this data is essential to investment planning.

Your question poses a classic tug-of-war dilemma because you are apparently asking your money to do two opposite things at once: grow and produce income. That's like trying to drive both east and west at the same time. You can do one, and then the other. But you can't do them both, and the harder you try, the more frustrated you'll become.

In simple terms, limiting ourselves to stock investments, the way to invest for growth is to buy stocks of companies that reinvest their profits in building the companies, developing new products, etc. If the company is successful, this builds the stock price. The company could pay its profits to shareholders in the form of dividends, but it doesn't, because it gets a better return on that money by reinvesting in its own business. The result: You get no (or only minimal) dividend income; but if you're lucky you get growth.

The way to invest for income is to buy stocks of companies that have a steady business but not much room to grow. Utilities are the classic example. Typically, they have already saturated their territories, and they pay hefty dividends to shareholders. But those dividends may not be increased for long periods of time. The result: You get income, but little growth.

Now here is the investment approach you need to take: Figure out how much income you need, then invest enough in fixed-income funds to produce that. Invest the rest of your portfolio for growth. That's the basic asset allocation answer to your situation.

As a rule of thumb, assume you can earn 8 percent in fixed-income funds. The calculation works like this: Your desired annual income divided by the assumed interest rate equals the amount you must invest to produce that income. For example, if you need $45,000 a year, divide that by 0.8 percent. The answer, $562,500, is what you must invest in order to produce the $45,000 income. Whatever you have left, invest for growth.

These calculations will tell you in a flash whether your nest egg is large enough to meet your income needs. If it is, follow the investment suggestions below.

But if your nest egg is too small, you have three choices: The first and least risky choice is to reduce your expectations for the income you need. Second, you can go back to work on a fulltime or part-time basis to build up your nest egg. Third, and this is the most risky, you can invest more aggressively, hoping for higher returns that will allow you to withdraw enough to meet your needs. You may have to employ some combination of two or even three of these methods.

For your investments, a few good income funds to consider are Strong Advantage, American Century Intermediate Treasury, Warburg Pincus Global Fixed Income, T. Rowe Price Spectrum Income, Vanguard GNMA, Vanguard High-Yield Corporate and Vanguard Long-Term Corporate Bond. For growth investments, consider T. Rowe Price Spectrum Growth, Vanguard 500 Index, Schwab 1000 and T. Rowe Price International Stock funds.