Stock market volatility means that asset valuations will fluctuate.
For many investors, seeing the value of their investments go down may be a hard pill to swallow. It is easy to doubt the effectiveness of your investment strategy when asset prices start plummeting. The anxiety that results from this can push many to sell off their assets.
Very few investors have the emotional determination to hold on to assets despite the drawdown on their portfolios.
If you are not the type that can stick to their guns when the chips are down, then you may perhaps have to consider a defensive investment strategy.
In this article, we take a look at what this investment strategy is, and how you can use it to minimize risks to your portfolio.
What is a Defensive Investment Strategy?
Defensive investing entails an investing strategy in assets that are considered defensive, or – that are not sensitive to economic cycles or changes.
Due to their resilience to economic fluctuations, including defensive assets in your portfolio can help preserve the value of your investments and generate modest returns.
The goal of a defensive investment strategy is to reduce the risk of losing principal. Rather than targeting high-growth assets like stocks, which are high-risk, defensive investing takes a conservative approach.
It invests in relatively safe assets that provide stable, long-term returns with minimum volatility.
A common tactic used by defensive investors is building a portfolio mix made up of low-risk assets such as:
- cash
- bonds
- ETFs
- dividend-paying stocks
- certificates of deposit (CDs)
- guaranteed investment certificates (GICs)
- stocks in defensive sectors such as healthcare, utilities, consumer staples
5 Types of Defensive Investment Strategies
There are various types of defensive investment strategies you can use to protect your portfolio from drawdowns.
Let’s have a look at the most commonly used defensive strategies.
1. Diversification
Diversifying your portfolio means putting your money into many different types of assets, like stocks, bonds, and cash.
The idea behind portfolio diversification is that you spread your investment across different assets like:
- defensive stocks
- blue-chip stocks
- high-quality bonds
- ETFs
Doing this reduces the effect of market and/or asset drawdown on your portfolio.
2. Rebalancing
Portfolio rebalancing refers to changing your portfolio’s composition from time to time, depending on its performance and macroeconomic conditions.
For example, if the stock market is particularly strong because of low-interest rates, then the portfolio may have a higher composition of stocks and low composition of bonds, ETFs, etc.
On the other hand, if there is a recession or high-interest rates, then your portfolio can reflect a higher composition of bonds, and lower composition of sticks.
3. Dollar Cost Averaging
A dollar cost averaging strategy is when you invest a set amount of money in a certain asset regularly.
This can help even out the ups and downs of the market and reduce your risk of volatility. It also reduces the average purchase price of the asset.
4. Value Investing
Value investing is a defensive investment strategy whereby the focus is on companies with strong balance sheets and good performance records.
The trick here is not just identifying the companies, but buying them when they are selling for less than their intrinsic value. During periods of economic distress, value stocks can help hedge your portfolios against volatility because their prices are much more stable than growth stocks which tend to be volatile.
5. Stop Loss Orders
If you are actively trading or investing during economic downturns, using stop-losses can help minimize losses.
A stop-loss is an order to your broker to sell a stock when its price falls to a predetermined level. Setting up stop-losses helps an investor shed falling stocks automatically to minimize losses.
Benefits and drawbacks of Defensive Investing
Like all investing strategies, Defensive investing, like other investing strategies, has its pros and cons. it helps to know the upsides and downsides before committing to a particular path.
A defensive investor may find the risk-averse nature of a conservative portfolio appealing, but it’s still critical to be aware of the pros and cons of this investing strategy.
4 Upsides of Defensive Investing
1. Capital preservation
Defensive investing concentrates on capital preservation by investing in low-risk assets that are less likely to sustain substantial losses in a volatile market.
This can aid investors in avoiding significant losses and preserving their wealth.
2. Income generation
Most defensive investments generate income in the form of dividends or interest payments.
This can provide investors with a steady income stream they can use to fulfill their financial obligations or finance additional investments.
3. Hedge against market fluctuations
Defensive investments are typically less sensitive to market fluctuations, so they are less likely to experience large price shifts.
This makes them a more stable option for investors with a low-risk tolerance or aversion to stock volatility.
4. Diversification
A defensive investment strategy can assist investors in diversifying their portfolios and minimizing overall risk.
This is particularly advantageous for investors whose possessions are concentrated in a single asset or sector.
3 Downsides of Defensive Investing
1. Limited growth potential
Because defensive investments are typically less hazardous than investments in equities or other growth-oriented assets, they may offer a lower potential for high returns.
This indicates that investors pursuing a defensive strategy may lose out on opportunities for substantial gains.
2. Underperformance in rising markets
In a bull market, defensive investments may underperform. Because these investments are designed to be less susceptible to market fluctuations, they may gain less from market appreciation.
This can make them less appealing to investors seeking to maximize returns.
3. Limited investment alternatives
Defensive investing typically entails investing in low-risk, income-generating assets, such as government bonds and dividend-paying equities.
This restricts the investment opportunities available to investors and may prevent them from gaining exposure to other asset classes or industries that may offer higher returns.
When Should You use a Defensive Investment Strategy?
While a defensive investment strategy helps to protect the value of your assets, knowing when to use them is equally important.
As seen from its shortcomings, if applied wrongly, you could be missing out on potential gains. Timing is key in the application of this strategy.
Let us examine when you should consider using a defensive investment strategy.
Risk-averse
If you have a risk-averse approach to investing, then the conservative nature of a defensive investment strategy will appeal to you.
Being risk averse could be due to your nature. However, other reasons like age (if you are close to retirement), capital, or knowledge may make you take a cautious approach to investing.
Close to retirement
If you are close to retirement, then a defensive investment strategy is the best option for you.
Investment mistakes made at the later stage of your life may be difficult to receive, unlike when you are younger. This focus at this stage of your life is protecting your nest, not taking on risks.
Market downturns
Defensive investing is helpful in times of market downturn and volatility.
In turbulent market environments, a defensive investment strategy helps to reduce the risks from drawdowns while ensuring moderate returns.
The Takeaway
A defensive investment strategy could be a good way to reduce risk and protect the value of your investment.
Knowing the different kinds of defensive strategies available enables you to choose the one that fits the economic cycle and your financial needs and goals.
Even though every investment has some risk, putting more defensive assets in a portfolio can help protect it from volatility.
