Much has happened in the financial markets in the past 20 months. Many investors and financial advisors are shell-shocked. Some of the investment principles we have all learned and practiced successfully no longer seem relevant. What new principles may come out of the downward market spiral we have just experienced and may continue to experience?

First, your clients need to have an objective, clearly defined and disciplined method of investing-their investment plan. Investors and their advisors should work on short, medium and long-term investment goals with concern for moderating the risks of the investor's portfolio for each of those time horizons.

Traditional asset-allocation strategy has long been the preferred portfolio construction methodology of many investors, but the potential value of this strategy is currently open for debate due to recent market movements. An asset-allocation strategy assumes that a target percentage of a given portfolio will be allocated to each separate asset class (stocks, bonds, REITs, etc.) of a portfolio and all allocations will be rebalanced periodically.

To be sure, the Modern Portfolio Theory method of asset allocation has worked over long time periods, but the fact is, it is based on historical data: historical prices, historical volatility and historical relationships between assets.

And recently, this method did not hold with the reality of the markets. Most domestic and international financial assets, contrary to conventional wisdom, all declined simultaneously. Thus, there was not a relatively higher priced asset (other than U.S. Government securities, which became a safe haven) to sell in order to reallocate to a lower-priced asset for possible future appreciation. It seemed like everything except U.S. Government securities was falling in price. And most investors were stuck, hoping for a market rebound, yet simultaneously concerned about selling too early, lest they would miss a hoped-for rebound.

Indeed, if we paid attention to all the rules and practiced all these investment techniques to the letter, we still might have lost close to 50% of our investments in the last 20 months. Why? Because the international credit crisis spilled over to the equity markets of world economies, and most classically diversified portfolios lost value. If all assets in a portfolio simultaneously lose value (positive correlations), no asset allocation strategy is going to increase the value the portfolio. And that is what happened recently to most investors' portfolios.

Using Risk Mitigating Investments in Portfolio Construction

If classic asset allocation did not prevent most portfolios from losing value, what might investors do to protect their portfolios, now and in the future? How can we be prepared for another "Perfect Storm" in the investment world?

We suggest that employing some risk-mitigating investment strategies in a classically diversified portfolio may help increase relative returns with less risk. Consider adding investments that are backed or insured by either the U.S. government (such as U.S. Treasuries or FDIC-insured CDs) or by a very stable insurance company (such as insured municipal bonds). Build in portfolio guidelines designed to limit downside risk (such as stop-loss provisions, put-option features or long/short funds). Use investments with a high probability of delivering full value, either promised or expected, in the future, such as life insurance, annuities or long-term health care. This last category is not traditionally considered portfolio investments, but can still be an important part of a portfolio if an unforeseen event forces investors or their dependents to withdraw assets, especially at a bad time in the market which places their investment goals at risk.

Finally, consider investments that are likely to hold their value in volatile times, such as gold.

The following is a hypothetical asset allocation that we suggest as a basis. Note that fully 30% of this allocation is dedicated to risk-mitigating investments: Cash/equivalents, 5%; equities 30%; fixed income, 25%; alternative investments, 10%; and risk-mitigating investments, 30%.

James MacPherson is managing director of Financial Products Group, a financial products and services advisory firm. He can be reached at jmac@financialproductsgroup.com.