Save your 401(k) from next Lehman-style meltdown

It has been a year since the music died on Wall Street.

What have many people done to protect their life savings from events such as the collapse of the 158-year-old Lehman Brothers and the ensuing financial pandemic? Next to nothing.

Market risk can and should be pared from retirement portfolios, though millions are just as vulnerable as they were a year ago. Most people have left their dominant stock allocations untouched. The key is to add more bonds.

The conventional wisdom that the historical returns of stocks beat bonds was and is misleading. If you are retiring during or immediately after a bear market, long-term returns are irrelevant.

Consider the period after the dot-com bubble exploded. Before the meltdown, didn't you think technology stocks were going to create a New Economy that would produce profits for decades?

The tide turned fast. Let's take 1999 through last year. You would have lost money in large-company stocks in four of those years (2000, 2001, 2002 and 2008). What if you retired in 2003 and had most of your money in big companies?

The chances are slim that your retirement plan has access to sophisticated portfolio-insurance strategies available to institutional investors.

Because options for individuals are limited, you have to buffer your portfolio with an equal mix of stocks and bonds. The single-worst year for this formula was 1931, when such an investment would have lost about 25 percent.

Compare the 1931 stock-bond mix with a 43 percent decline for an all-stock portfolio in the same year, according to Ibbotson Associates, a Chicago-based research firm.

In 2008, the 50-50 mix would have lost only about 10 percent, which was the second-worst year on record for major stocks. Had you reduced your equity portion to 30 percent and upped bonds to 70 percent, you would have been in the black — up 3 percent.

Increasing your bond holdings is dull, though, which is why most people don't do it during a bull market. We have built-in emotional circuits that tell us that regret from missing out on profits is far more motivating than heading for cover.

Risk analysis goes out the window when everyone is enamored of the same idea and we lose sight of what we can lose.

Quick quiz: What's the chance of losing one quarter of your money in stocks? Very, because it has happened twice in my generation and twice in my parents' lifetimes. It will certainly happen again.

Oh, but we can't resist what our neighbors are doing. "Animal spirits," to cite economist John Maynard Keynes, compel us to follow the herd, even when it is headed into unsafe territory.

Let's go back to those splendid stock returns when everyone was making money. True, in 1999, big companies were up 21 percent. As it was the end of the dot-com bubble, many investors dumped almost everything they had into equities — and stayed put.

Buy-and-holders should have reversed course.

Those who kept a 100 percent stock allocation would have lost 9 percent, 12 percent and 22 percent, respectively, in the three following years. Of course, they would have been rewarded in stocks from 2003 through 2007. Then the bottom fell out again last year as the biggest stocks plummeted 37 percent.

Government policy does little to short-circuit investment myopia.

Along with automatic enrollment for individual-retirement accounts for small businesses and the ability to reinvest tax refunds in savings bonds — both recently proposed by the Obama administration — we should be able to easily insulate our entire retirement fund.

Even though conventional bonds are part of the solution, you still face interest-rate, credit and inflation risk from holding them. When interest rates go up, you could lose principal in all but consumer price-indexed bonds. A more easily accessed, principal-guaranteed vehicle is needed.

Enter the "R" Bond, a concept under development in the halls of the U.S. government.

The Treasury Department hasn't provided details on this bond yet. If it isn't linked to the stock market and the principal is guaranteed, your retirement plan could buy them automatically and you could even predict how much money you would have in the future.

If the R bond survives the twisted intrigues of Washington and Wall Street, it might become one of the most useful financial products since the fixed-rate mortgage.

To understand why the R bond is important, you need only look at your 401(k) balance.

Sure, your funds may have recovered somewhat, but consistent 401(k) contributions tend to paper over stock-market losses since account balances are rising.

The one truth that remains since the Lehman-triggered rout? The more you need to protect principal, the less market risk you should take.