An Arsenal for the Defensive Investor

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The notes pay interest twice annually, and the principal is adjusted each time to correspond with changes in the CPI. For example, a $100 note returning 2.5% would become a $105 note returning the same percentage if yearly inflation were 5%.

Yet TIPS aren't perfect either, warns Hanau. TIPS correspond to the CPI, an inflation index that many believe understates the impact of rising fuel or food prices, he says—the very sectors that economists agree are driving inflation today. (Morgan Stanley (MS), for instance, recently told clients that TIPS don't correspond to inflation as well as derivative contracts tied to inflation expectations, according to a recent Bloomberg article.)

4. Foreign government bonds

Buying bonds issued by major developed countries including Germany or Japan is another safe way to best U.S. interest rates. Two-year German government bonds, for instance, yield 4.32%—170 basis points over the U.S. alternative. Stick to countries in the G7, though, says Merrill Lynch's Bernstein. Since underdeveloped countries can tend to have more volatile interest rates, rampant inflation, or less access to capital, the risk of government default is greater in those cases. "There's a big difference between major developed countries and emerging markets," says Bernstein. "The key thing is quality." Investors can buy individual government bonds through brokers or invest in mutual funds like the T. Rowe Price International Bond Fund (RPIBX), which invests primarily in high-quality bonds outside the U.S.

5. Shorter-maturity bonds

If investors want to bolster their portfolio's defenses, they don't necessarily need to tweak their stock-to-bond ratio. Instead they can emphasize bonds with shorter maturity dates in the fixed-income portion, where the risk of default is lower. "If you had started in bonds with a 7- to 10-year maturity and switch to the 1- to-5-year maturity range, you've immediately taken risk out of your portfolio," says Gregg Fisher, president and chief investment officer of Gerstein Fisher in New York. "And you still haven't reduced your stock market exposure." That way, investors don't have to absorb the capital gains taxes from selling off their stocks.

6. Options

Then there's the old-fashioned approach to stock insurance: options. Investors with long positions in equities can always put a floor on potential losses by buying put options, which rise in price if the value of the underlying stock declines. For instance, as of July 29, Apple (AAPL) common shares traded at $157.08. The asking price for a September 2008 put with a $140 strike price was $20.80, which means that, if the stock price fell below $140, an investor could offset the loss by exercising the option. But it's expensive. "You will eventually give up returns by owning the insurance," says Fisher. "But if it makes you sleep at night, it's definitely something to consider."

The better strategy, says Florida hedge fund manager Michael Levas, is selling covered calls. Using this tool, investors agree to sell the stocks they own if the stock value exceeds a future price, but if the stock value falls, and the option expires unexercised, they keep the option premium. Again using Apple as an example, an investor with Apple shares could sell a September 2008 call with a $160 strike price for $9.70 per share. If the price rises past $160, the investor would receive $160 from the sale of each share and pocket the additional $9.70 per share; if the price dropped, the investor would still hold onto the stock but pocket the extra $9.70.