Excerpted from Safety Net by James K. Glassman © 2011 James K. Glassman. Reprinted by permission of Crown Business, an imprint of the Crown Publishing Group.

By James K. Glassman

The Shift to Bonds

Because of my concerns about the strength of the U.S. economy and worries about continuing volatility, the Margin of Safety strategy requires that allocations--across all time horizons--shift from stocks to bonds. For a retirement portfolio, a shift of twenty to thirty percentage points is necessary. Let's take a specific example.

A forty-five-year-old mid-level corporate executive plans to retire at age sixty-five. Besides Social Security, he expects no other retirement income beyond his 401(k) and other investments. My assessment until recently would have been that he should hold 90 percent of his portfolio in stocks and 10 percent in bonds. Then, over the next ten years, he should slowly shift to 80/20 stocks and bonds; then over the next ten, to 70/30 or 60/40 stocks and bonds. Now, under the Margin of Safety strategy, I prescribe a far more conservative allocation plan: 50 percent stocks and 50 percent bonds through the period between age forty-five and sixty-five. On retirement, he should reassess and decide how much income he needs for day-to-day living, but during the accumulation stage, 50/50 is the right proportion.

If U.S. growth flattens out--and all indications are that it will--then returns from stocks will probably fall below historic averages. Possibly far below. Stocks, remember, are priced based on expected profits over the life of their underlying businesses. If investors assumed that profits would rise by 6 percent a year and now, because of reduced growth, the expectations drop to 3 percent a year, then the stock price will drop--despite the fact that profits will continue to rise.

Bonds, on the other hand, are likely to benefit from lower growth--as long as that growth does not go too low. They do, however, carry two kinds of risk. First is credit risk, meaning that the borrower (the corporation or government issuing the bond) might not be able to pay you back. Second is inflation, or interest-rate, risk, meaning that interest rates might rise after you buy the bond. If interest rates rise, then the price your bond will fetch in the market will fall. That seems counterintuitive, but imagine that you bought a $10,000 bond that matures in ten years with a coupon of 6 percent. The borrower--that is, the seller of the bond--promises to pay you $600 annually for ten years, then to repay the entire $10,000 in principal.

So far, so good. Now, fast-forward one year. Imagine that you want to sell your bond and that, because of worries about inflation, the same borrower (the federal government, for instance) must offer ten-year bonds at 7 percent interest, instead of 6 percent interest, to attract lenders. These new bonds pay $700 a year. Obviously, anyone with $10,000 to invest would prefer to buy the bond paying $700 to your bond paying $600, so, to attract buyers, the price of your bond must fall. If it drops to $8,500, then the effective current yield ($600/$8,500) jumps to about 7 percent, so your bond can compete in the marketplace, but you have suffered a loss of $1,500.

Now, understand that this loss in value only applies if you have to sell your bond. If you hold it to maturity--the specific date on which the government promised to repay you--then you get the entire face value of the bond, or $10,000. But even if it doesn't seem as if you have lost anything if you wait until maturity, you really have. You have lost the opportunity to earn the higher interest that new bonds are paying.

For this reason, one way to lower the risk in buying bonds (that is, the risk in lending money to a government agency or a corporation) is to choose debt that matures in the short or medium term--say, between two and eight years. That way, if rates rise, you can wait a short time until the bond matures rather than taking a loss. Yes, there is an opportunity cost, but you can fairly quickly take the proceeds and buy a new bond at a higher rate. In general, when economic growth is modest, there's less chance of inflation, so interest rates are low. In a crisis, investors typically rush to U.S. Treasury bonds as a safe haven from economic storms, again driving down interest rates. But if the U.S. economy gets very bad, investors may decide to flee T-bonds because of credit risk--the worry that the American government, like the Argentine, Russian, and Greek governments before it, might not be able to pay the interest and principal. Such an event would be akin to seeing a black swan. It can happen, but the best bet is that bonds will provide more consistent returns than stocks and that, in case of another severe economic downturn, bonds will be hurt less than stocks--and might even be helped.

No one knows for certain about the economy, but the Margin of Safety strategy protects investors against the worst while providing the chance for good gains. Consider history. A portfolio consisting of 90 percent stocks and 10 percent bonds returned an average of 9.6 percent between 1926 and 2009. (In this case, the stocks are represented by the S&P 500 and the bonds by an index of long-term U.S. government debt.) A portfolio split 50/50 between stocks and bonds returned 8.1 percent. So, if history is a guide, you are sacrificing 1½ percentage points by going 50/50.

Because my prediction is that the future will be worse than the past for U.S. stocks, your sacrifice may be closer to one percentage point a year. But even two points is not too much for insurance against a rotten stock market. How rotten? A 90/10 stock-bond portfolio has lost as much as 40 percent of its value in a single year while a 50/50 portfolio has never lost more than 25 percent. Let's look at five-year holding periods, using Morningstar data. For 90/10 portfolios, the worst loss was an annual average of 10 percent, knocking the value of a $500,000 nest egg down to about $300,000. For 50/50 portfolios, as noted in the Introduction, the loss averaged less than 3 percent, reducing the nest egg to $430,000. Just as important, over ten-year periods, the excess returns from 90/10 portfolios are not so much greater in the best year--a maximum of 18.5 percent versus 17 percent for 50/50 portfolios. So you're not giving up all that much when you default to 50/50.

The Margin of Safety strategy is anchored in a 50/50 rule for investors in their forties, fifties, and sixties. If you're younger, you can afford to increase the proportion of stocks to 70/30--but beware. Only investors who are willing to tolerate a good deal of risk and are putting money away for the very long term should opt for portfolios with stocks representing more than half their assets. The real danger of volatility is that your short-term losses become so psychologically unbearable that you dump your stocks at precisely the wrong time and miss the recovery. The best way to avoid that danger is by maintaining portfolios that don't fluctuate so wildly. And maintaining is the operative word here. You need to rebalance your portfolio every year to bring your investments back to target proportions. Here's an example of what happens if you don't rebalance. Assume a $100,000 portfolio split 50/50 between two low-expense mutual funds issued by Vanguard: for the stock portion, 500 Index; for the bond portion, Long-Term U.S. Treasury.

At the start of 2008, the portfolio had $50,000 in the stock fund and $50,000 in the bond fund. In 2008, stocks fell sharply and bonds rose smartly, so by the end of the year, the portfolio looked like this: $32,000 stocks, $64,000 bonds. Instead of a 50/50 ratio, the proportions are now 34 percent stocks, 66 percent bonds. At this point, you have to rebalance: sell $16,000 worth of bonds and buy $16,000 worth of stocks to bring the ratio back to 50/50.

If you don't rebalance at the end of 2008, then, by the end of 2009, your portfolio would be $39,000 in stocks and $49,000 in bonds for a total of $88,000--a loss over the two years of about 12 percent. But if you do rebalance, you would have $58,000 in stocks and $42,000 in bonds for a total of $100,000--breaking even. Then, it's time to rebalance again at the end of 2009, selling about $8,000 in stocks and buying the equivalent in bonds. Rebalancing is not always as elegantly beneficial as this example indicates, and it does generate capital gains taxes. So try to restrict your rebalancing to tax-deferred accounts, such as IRAs and 401(k) plans, or, better still (if you can afford it), rebalance by buying more stocks or bonds rather than selling one category and buying the other. But it is absolutely necessary to keep your portfolio as stable as you intended when you established the asset allocation in the first place. It's easier to let a mutual fund manager do the rebalancing--and the stock and bond selecting. Under the rubric balanced, many investment firms offer funds that allocate stocks and bonds at a ratio that's close to the norm I suggest.

One of the best in recent years has been Mairs & Power Balanced. Despite an expense ratio of 0.8 percent (there's no load, or up-front fee), it has produced an annual average return for investors of 8.7 percent over the fifteen years ending in early December 2010, compared with 6.5 percent for an investment in Vanguard's 500 Index Fund. Just as important, the ride has been relatively smooth. In 2001, when the Vanguard fund linked to the large-cap index fell 12 percent, Mairs & Power Balanced fell only 1 percent; in 2002, the Vanguard index fund dropped 22 percent, but the balanced fund fell only 6 percent. In the disaster of 2008, Mairs & Power Balanced outperformed the Vanguard stock index fund by sixteen percentage points, and when the stock index fund rose 26 percent in 2009, the balanced fund was not too far behind at a gain of 21 percent.

As I write, Mairs & Power Balanced divides its assets this way: 57 percent stocks, 39 percent bonds, and 4 percent cash. But the manager of the fund, William Frels, who has held the job since 1992, has discretion over allocation, not you. The main limitation is that the prospectus calls for having at least one-quarter of the fund's holdings in bonds. Still, this balanced fund--unlike many others--changes its allocations very slowly. I like its style.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.