Sturdy strategy of "laddering" offers support

Bank failures, bankruptcies and bailouts. Is it mattress-money time?

I know it's important not to panic, but an awful lot of us are feeling sheepish with the wolves dominating the financial headlines. Is it time to chuck all of your stocks and do a total retreat into bonds?

To the risk averse who want no more stock-market risk in their portfolio, it often looks like the only way out. It's one route, but not the only one. Stan Richelson, a financial planner at Scarsdale Investment Group in Blue Bell, Pa., and co-author with his wife, Hildy, of "Bonds: The Unbeaten Path to Secure Investment Growth," says you'll have to see bonds as the ultimate bulwark against financial-system risk.

"You're only seeing a piece of it," he says, referring to as-yet-unrevealed financial crises that will surface. "It's much worse than you think."

By design, the Richelsons' customized all-bond portfolios are neither diversified nor very interesting. He can accurately gauge returns every year but doesn't advertise performance.

Richelson uses a time-honored strategy called "laddering" to buy bonds. Individual issues with varying maturities are bought depending on when you need cash flow.

He debunks the conventional wisdom that rising rates are bad for bond investors. They are if you aren't holding the issues to maturity. Then you could lose money.

There's a low risk of default in government and high-quality municipal bonds, which makes up the bulk of holdings in his clients' taxable accounts.

Before he starts buying bonds, Richelson gets a clear picture of his clients' tax situation and cash-flow needs. He also takes an inventory of their financial and life goals. Then he structures a plan that avoids junk bonds, almost all corporate debt and bond mutual funds.

Here's a thumbnail of what a $500,000 portfolio might look like for a couple (both age 45) with one child, age 15, who'll enter college at 18.

The "Smiths" want to pay for their son Robert's college education by saving $100,000 for tuition, assuming their son isn't going to a private school. They also aim to pay for a $50,000 kitchen remodeling in five years and retire at 65.

They live in California, paying marginal rates of 9.3 percent for state income tax and 28 percent on federal.

The couple buys four, $25,000 California zero-coupon (deferred payment) muni bonds coming due in 2011, 2012, 2013 and 2014 for Robert's college bills.

They also buy a $50,000 discounted tax-free municipal bond coming due in 2013 for the kitchen project.

The Smiths invest the remaining $350,000 in a laddered portfolio of seven municipal bonds of $50,000 each, maturing from 2018 to 2024. They pay current interest that's invested in additional municipal bonds.

While the Richelson's sample portfolio poses almost no credit risk, there are other perils.

No matter how much income security Richelson promises, he can't vanquish the inflation gremlin. His portfolio isn't risk-free.

Loss of purchasing power, which hurts all investors, is particularly damaging to bondholders who aren't actively buying higher-yielding bonds to keep up with the rising cost of living.

If you were to aggressively fend off inflation, conventional bonds wouldn't be the preferred weapon.

Treasury Inflation Protected Securities, or TIPS, and I-Bonds from the U.S. Treasury, are indexed to the Consumer Price Index and guaranteed by the government.

You'll also need to protect against commodity-price increases.

The Pimco Commodity Real Return Strategy fund, another one of my favorite holdings, mixes TIPS with commodity-derivative instruments. It's up more than 8 percent over the past year.

Bonds also won't capture any earnings growth from non-U.S. markets with robust economies. The new Vanguard Total World Stock Index exchange-traded fund is worth considering for that purpose.

Along with an eye on inflation and international growth, you need to focus on your life needs and forget what's preoccupying Wall Street at the moment.

Do you have college bills coming up? Are you buying a first or second home? Are you retiring?

Those events are typically tied into predictable dates and you can still adjust your portfolio with bonds to safely deliver cash when you need it. You can't reliably do that with an all-stock portfolio.

If this tormented market provides any lessons at all, it's the need to refocus on immediate and future cash-flow needs. Use your mattress for sleeping.