Defensive investment strategies are designed to protect your portfolio from losses rather than to increase its value. There are two primary reasons for considering a defensive strategy.
US stocks have been in a bull market since March 2009, a 12-year run of gains. That’s been a profitable period for US stock investors. It also raises concerns about “recency bias”: the assumption that things will keep going as they have been recently.
We’ve seen periods with dramatic stock gains before. The bull markets of the late 90s and the mid-2000s were followed by steep market crashes, recessions, and BIG losses for investors who had settled into an aggressive investment pattern.
Markets bounced back, but investors who adopted defensive investment positions before the crashes suffered less damage. The more-defensive Dow 30 suffered much less severe losses than the S&P 500 in both the 2001-2002 and 2008-2009 recessions.
These indicators raise suspicions that the current bull market may be peaking, but that’s not a consensus view. Many analysts also believe that the end of the COVID-19 pandemic could propel an economic recovery and push markets even higher.
Markets rise and fall. Recessions and bear markets happen. Nobody can time exactly when they will happen, but when investors face concerns about over-valued markets, many of them begin considering defensive strategies. Understanding those strategies can help you preserve your capital when a bear market arrives.
These are four common defensive investment strategies:
Many investors choose a specific asset mix designed to fit their risk profile. This mix defines what percentage of the portfolio is invested in each asset class. Over time some assets perform better than others, which moves the portfolio away from the original allocation. Rebalancing typically involves selling part of the high-performing section of the portfolio and adding to the low-performing classes. It sounds strange to discard productive assets in favor of less productive ones, but the high fliers have farther to fall when things turn down, and history shows that over time the performance of different asset classes tends to equalize.
Dividend-paying stocks are a staple of the defensive portfolio. Dividends are typically paid as a flat amount per share, so the dividend yield rises as the stock price falls. If a stock selling at $50/share pays a dividend yield of $2/share, the yield is 4%. A price drop to $30/share with the same dividend puts the yield at 6.67%. If you buy in at that price, your yield remains the same even if the stock price rises, an opportunity for both income and capital gain.
When the price of a dividend-paying stock falls abruptly, investors seeking dividend income tend to step in and buy, stabilizing the price. This makes stocks with a strong history of dividend payments a core part of most defensive portfolios.
Investors have traditionally viewed gold as a “safe haven” investment during times of economic turbulence. Gold has often – but not always – gained in value during recessions, including the last two US recessions. (per WSJ). Buying and holding physical gold can be complicated, but investors can gain gold exposure by buying gold ETFs or shares in gold mining companies.
When markets turn down, cash is king. That’s not just because cash holds value when stocks fall. For seasoned investors, a market crash isn’t a disaster. It’s an opportunity. A strong cash position leaves you ready to pick up shares of quality companies at bargain prices. You won’t call the bottom exactly – nobody ever does – but if you’re selling high and buying low, you’re on the road to investing success.
The defensive strategy you choose will be determined by your financial situation:
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There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.