NEW YORK (CNN/Money) - The balances of our IRA and regular taxable accounts have grown large enough that a severe market downturn would be devastating for me and my wife. How can we protect our retirement savings? Should we consider derivatives and options, or is there something else we can do?

-- B. deLoeuf, Missoula, Montana

It's only natural that as your retirement savings begin to grow that you become more anxious about incurring losses. After all, even though a 20% loss is still a 20% loss regardless of the size of your account, seeing the balance of a $500,000 retirement stash drop $100,000 is a lot more gut wrenching than watching a $50,000 account decline by $10,000.

But it's precisely because more is at stake both financially and emotionally when you're dealing with bigger bucks that you've got to step back a moment and devise a strategy for dealing with investing risk that's based on logic, not fear and emotion.

So let's go over your choices.

One would be to buy a specialized investment like a derivative or option that's designed to protect a specific part of your portfolio. For example, if you own General Motors (up $0.16 to $26.77, Research) stock and you're worried that all the talk of GM's health-cost and pension problems will continue to drive the stock below its recent price of $27 or so a share, you could buy a "put" option on GM shares at say, $25. Such an option would give you the right, but not the obligation, to sell GM shares at $25 for a specific period of time. In effect, you would be buying insurance that would limit your potential loss to $2 a share. Alternatively, if your overall stock holdings were similar to a broad index like the Standard & Poor's 500, you could protect the value of your entire portfolio by buying a put option on the S&P 500 index.

While this type of insurance can work in some situations, I don't think it's appropriate for individuals who are investing for long-term goals such as retirement. For one thing, you've got to pay a premium to buy these options. And if you want to renew the protection after the option expires, you've got to pay that premium again—and again, and again as long as you want that insurance. This makes no sense to me because if you're investing for the long term, why pay to protect yourself against short-term fluctuations that don't mean very much over a long period of time?

Another way would be to move all or nearly all of your portfolio into "safe" investments like CDs, money-market accounts or short-term bonds. That will protect your principal all right. But it will also stunt the long-term growth of your portfolio. Which means you may not accumulate a large enough nest egg to support you comfortably in retirement, and your savings may run out while you've still got a lot of living to do.

So what's the solution? I'd recommend a sensible asset allocation strategy—that is, divvy up your assets among stocks, bonds and cash so that you have enough exposure to equities to gain the long-term growth potential you need, but you also have some protection against market setbacks. This strategy also works as a hedge in another way. Although stocks have historically delivered the highest returns of all financial assets by a large margin, there's no guarantee that will happen in the future—or, if it does, that stocks will provide as big an edge. Thus, having some of your money in bonds means your portfolio still has a good shot at long-term growth even if stocks don't romp as they did in the past.

As for setting the allocation that's right for you, it really comes down to how long you'll have your money invested and what sort of short-term ups and downs you're willing to accept in the value of your portfolio. The longer your investment horizon, the more you want in stocks. The less volatility you can stomach, the more in bonds. To translate this principle into actual percentages of stocks and bonds, I have two recommendations.

The first is to go to our Asset Allocation tool [LINK TO cgi.money.cnn.com/tools/assetallocwizard/assetallocwizard.html]. Just answer a few questions to judge your time horizon and risk tolerance and, as Emeril would say, Bam! You get instant advice on how to divvy up your portfolio among different types of stocks and bonds.

Or you can check out the Dream Retirement package [LINK TO money.cnn.com/pf/features/retire_guide/] in the November issue of MONEY. You'll want to pay particular attention to The Right Investment Strategy [LINK TO money.cnn.com/2005/10/07/retirement/dreamretire_pay_0511/index.htm] and its companion piece, A Plan For Every Stage [LINK TO money.cnn.com/2005/10/07/retirement/dreamretire_stages_0511/index.htm]. After reading those stories, you'll come away with allocation advice you can apply to your situation, as well as recommendations for specific investments to carry out your strategy.

One final tip: After you've settled on a stocks-bonds mix that's right for you, you may have to adjust it from time to time. For example, if stocks have a big run and bonds suffer, your portfolio may become a bit heavy in equities. Similarly, as you age, you may also want to tilt your mix a bit more toward bonds—that is, sell of some of your stock holdings and plow the proceeds into bonds—to prevent large setbacks when you're on the verge of retirement.

Of course, selling stocks or bonds in which you have gains could generate taxes. So to the extent you can, you would want to adjust your portfolio's mix by investing new money in whichever asset you need to bulk up. If your proportions have gotten too far out of whack to do that, then you should try to make the necessary adjustments in your 401(k), IRA or other tax-advantaged account. Since gains in such accounts are taxed only when the money is withdrawn, you can move money from stocks to bonds or vice versa to arrive at the stocks-bonds mix that's right for your portfolio overall—that is, both taxable and tax-advantaged accounts—without creating taxable gains. So you not only keep your allocation on track, but you do it in a way that keeps Uncle Sam's hand out of your pocket and leaves more of your money in your portfolio generating gains for you. In other words, a win-win for you.

I'm single and make about $80,000 a year. I own a home that's worth about $550,000, which is more than $100,000 than I paid for it, and I've just used $60,000 I previously had invested in a diversified portfolio of stock mutual funds in an IRA rollover to buy a $140,000 vacation home in Arizona that is now valued at $190,000. My question is, should I continue with this investment strategy for retirement or do something different?

-- Andrew Lam, Walnut Creek, Calif.

Investment strategy? I don't see any investment strategy. I see someone who went from having his wealth divvied up between real estate and a diversified portfolio of stock funds to a position where everything he owns is now pretty much riding on the fortunes of the real estate market.

I'd be more likely to call what you did "di-worse-ification" -- that is, the opposite of diversification -- and more speculation than true strategy.

As for that "vacation home" you bought with your IRA funds, well, depending on how you purchased it and how you intend to use it, you could be setting yourself up with big problems with the IRS.

I'll get back to that in a minute. But let's first talk about your so-called retirement investing strategy.

Assuming the figures you've given me are correct, I can't argue that your decision to dump your stock funds and put the money into real estate appears to have paid off.

The real estate market has been hot lately. But the question is whether this is a good long-term move. I'm not predicting a real estate crash. But as more and more people like yourself begin chasing returns in real estate and bidding prices up, the harder it's going to be for real estate investors buying at those higher prices to earn the same sort of returns we've seen in recent years.

After the big price runups on both coasts in the late 1980s and early 1990s, for example, house prices fell 10 percent to 20 percent in some cities and took five to 10 years to regain their old peaks.

For a look at how house prices have fared over the last 20 to 25 years in the areas you're interested in, download the House Price Index for Metropolitan Statistical Areas as of the second quarter of this year at the Office of Housing Enterprise and Oversight (OFHEO) site.

But aside from the prospects for real estate, a fundamental principle of investing is that you should diversify so your holdings aren't decimated if a particular market sector asset class gets clobbered.

To my way of thinking, that means you would own some stock mutual funds, some bond funds and some cash.

Real estate can be part of the mix. But I'd say only after you have the financial assets taken care of and even then I don't think real estate needs to be a very large part of your portfolio. I'd say 10 percent to 20 percent tops. I could see real estate fans wanting to push that figure.

But putting 100 percent of your wealth in real estate is going way too far. One can also argue about whether the best way to get that exposure is "sticks and bricks," or actual real property, or real estate-related stocks and funds. Simply from the standpoint of convenience, I'd say real estate stocks and funds are the way to go, particularly if you don't have a large amount of money to invest.

Now, back to that vacation home. It's unclear to me just how you used your IRA funds to purchase it. If you liquidated the IRA, paid tax on the distribution (plus a 10 percent penalty if you're under age 59 1/2) and then put whatever was left toward the vacation property, then you have nothing to worry about from the IRS.

I'm not saying that this would have been a smart move -- I'd have argued against it, figuring you'd be better off letting your money grow without the drag of taxes in the IRA -- but I don't see how you would run afoul of the IRS with this approach.

If, on the other hand, you actually used your IRA funds to buy the vacation home -- that is, the vacation home is now actually an investment within your IRA -- you could have trouble with a capital T.

It's perfectly legal to invest in real property -- a house, condo, land, whatever -- within an IRA. I don't think it's a particularly good idea for most people, but there's no prohibition against doing it.

There are, however, a number of restrictions, one of which is that you can't use a house your IRA owns for your personal use. So in your case, you can't use that vacation home for your own vacations. If you run afoul of this or another "prohibited transaction," the IRS could terminate your IRA, which would trigger taxes on the entire account value, plus a 10 percent penalty if you're under age 59 1/2.

For more on some of the ways you can get tripped up investing in real estate with your IRA, as well as the reasons I think real property is a good investment for IRAs for most people, you can check out an earlier column I wrote on this topic. I also recommend that anyone who owns real estate in an IRA or is thinking of doing so, check out IRS Publication 590 on the IRS web site and pay close attention to the section on Prohibited Transactions that begins on page 43.

To sum up, I recommend that you develop an actual investing strategy-that is, begin putting together a portfolio of stock and bond funds that's right for you. You don't mention your age. But if you read The Right Investment Strategy and its companion piece A Plan For Every Age, both of which appear in MONEY's November issue, you'll find an appropriate strategy for people at three different stages of retirement planning (mid-career, nearing retirement and already retired). You'll also find specific fund recommendations.

But the most important part is developing a plan, a coherent investment strategy moves you toward your goal of a comfortable retirement. Otherwise, what you'll probably end up with is a series of investments that looked good at the time (and maybe not so good afterwards) rather than a diversified portfolio of holdings that work in concert to give you an acceptable trade-off between risk and return.

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