Bonds Can Corral Your Risk

"Bonds are less of a buy-and-hold strategy than stocks because people don't usually hold bonds to their full maturities," says Sowa. "So it's better to have experienced bond fund managers looking after the portfolio."

Within the fixed-income portion of the allocation, Sowa's bond fund breakdown is 25% high-yield, 25% international (including emerging markets) and 50% high grade corporate and government bond funds.

Sowa's strategy is unique, however, and every financial adviser has a different formula for playing it safe. Rick Bloom, financial adviser for Michigan-based Bloom Asset Management, for example, says he "covers his clients' backsides" by putting 30% of their holdings into bonds if they have a moderate taste for risk. His bond breakdown calls for 20% short-term government, 20% Ginnie Maes, 15% Treasury Inflation-Protected Securities, 15% high-grade corporates, 15% high-yield and 15% global bonds.

A Ginnie Mae is a fixed-income security that represents an undivided interest in a pool of federally insured mortgages put together by the Government National Mortgage Association. The investor in a Ginnie Mae pass-through receives both the principal and the interest from the pool of mortgages.

Bloom says he likes Ginnie Maes for his clients' bond portfolios because he believes there will be less volatility in the sector now that the refinancing boom is over.

Like Bloom, Michael Joyce, a financial adviser at Virginia-based Michael Joyce & Associates, also sprinkles TIPS into his clients' bond portfolios, especially as the risk of inflation in the economy grows.

TIPS are a special type of Treasury note or bond that offers protection from inflation. As with other Treasuries, when you buy an inflation-indexed security you receive interest payments every six months and a payment of principal when the security matures. The difference is that the coupon payments and underlying principal are automatically increased to compensate for inflation by tracking the consumer price index.