Investing is never 100% smooth sailing. But when inflation and interest rates rise like they have through 2022, and the stock market turns volatile, it might be time to consider defensive investment strategies – if you haven’t already.
Moving at least some of your portfolio into defensive investments may help you to weather whatever the future brings. Keep reading to learn how to pick the best defensive investments during this difficult year for the stock market.
The Short Version
- A defensive investment strategy helps you ride out market downturns by reallocating your portfolio.
- One way to create a defensive strategy is to allocate more of your portfolio to bonds and dividend stocks and less to growth stocks.
- Even with a defensive strategy in place, there are no guarantees, and the market is still hard to predict, so you'll have to assess your risk tolerance and keep an eye on markets.
What Are Defensive Investments?
Conservative investments can include stocks in well-established companies that have demonstrated steady growth with high dividends and bonds (guaranteeing safety for the principal and interest income).
Along with conservative investment choices, you may want to move away from high growth, high P/E stocks that have been such reliable performers since the last major stock downturn ended in 2009.
Often there’s almost an inverse relationship between growth stocks and declining markets: The stocks that lead the way in rising markets tend to fall the hardest when markets decline.
Growth Stocks vs. Dividend Stocks
Let’s compare the year-to-date performance of two prominent stock ETFs, the growth-oriented QQQ and the dividend-producing NOBL.
The Invesco QQQ Trust (QQQ) is an ETF designed to track the performance of the NASDAQ 100 index. It represents the 100 largest stocks trading on the NASDAQ. These are primarily technology stocks in some of the best-performing companies on the market. Over the past decade, the fund averaged annual returns of nearly 19%, however, its value fell by about 25% it fell to just under $300 per share as of June 21. That’s a 25% decline from its 2022 opening of just over $400.
The ProShares S&P 500 Dividend Aristocrats ETF (NOBL) is at the opposite end of the spectrum. As the name implies, the fund contains dividend stocks. The Dividend Aristocrats is a collection of about 65 stocks from the S&P 500 with a history of consistently increasing and paying out dividends for at least the past 25 years.
Though the fund has produced average annual returns of just over 12% since its inception in 2013, it went down to just 6% in the first half of 2022.
Both funds have turned losses so far in 2022, which is hardly unusual given that it’s been one of the worst years for the market in a very long time. But the year-to-date loss in the QQQ is about four times higher than in the NOBL.
So, if you want to make a defensive adjustment in your portfolio, you might choose to invest more in NOBL over QQQ until the market swings upwards again.
What Can You Expect From a Defensive Portfolio?
The QQQ and NOBL funds comparison shows that growth assets perform better in rising markets and fall faster in declining markets. On the other hand, defensive assets don’t grow nearly as much in bull markets but experience much smaller declines during bear markets.
There’s an important message in that arrangement that should affect your expectations.
Notice that both funds declined, but the more defensive NOBL fund fell much less aggressively. And not only has it dropped less than the QQQ fund but also less than the S&P 500 on a year-to-date basis (a 6% decline for the NOBL fund compared with an 8.3% decline on the S&P 500).
The critical takeaway is that while a defensive investment strategy can minimize your losses, it may nonetheless fail to produce gains. Does that mean it’s a failed strategy? Hardly.
Gains and losses are part of investing in the stock market. We can even think of losses as a necessary step toward producing gains. After all, it’s all about risk/reward – if you avoid the risk, you won’t earn the reward.
A defensive investment strategy doesn’t eliminate risk. Instead, it allows you to focus on risk management within your portfolio.
Read more >>> Bear vs. Bull Market.
When Would You Need to Employ a Defensive Investment Strategy & For How Long?
This is a tricky question to answer. In hindsight, November 2021 would have been a great time to implement a defensive investment strategy. That’s about the time when the market peaked and then began an erratic decline.
This highlights the difficulty in shifting to more defensive positions.
- There’s no way to know precisely when the market will experience a long-term shift from growth to decline.
- There’s also no way to know when the decline will end and the market will return to growth. Timing the market is virtually impossible.
You'll miss out on gains if you implement a defensive investment strategy too soon. But if you move too slowly, your portfolio could get pummeled before you even realize what's happening.
It can be helpful to pay close attention to bigger-picture trends. Instability is a perfect example. The financial markets don’t like it and will typically react by declining. Inflation and international disturbances are examples of instability.
But one of the strongest indicators of a shift in market direction is interest rates. There are two major factors in the way interest rates affect the financial markets, stocks in particular:
- Rising interest rates can slow the economy, reducing sales and profits.
- High interest rates compete with stocks. When rates rise significantly, stocks become less attractive, as investors favor low-risk investments with guaranteed returns.
The above explains the current market decline. The Federal Reserve declared its intention to raise rates in the second half of 2021. So a further market decline in 2022 seems like a good bet, especially since the Fed is making it clear that they’re not done raising rates.
Your Own Risk Tolerance Should Influence Your Decision
Deciding when to move toward a defensive investment strategy isn’t all about tracking macro trends and attempting to read the tea leaves. You also need to factor your risk tolerance into the mix.
You can use the Vanguard Investor Questionnaire to help you determine what your risk tolerance is. Essentially, risk tolerance measures your comfort level with the potential to lose money in your investments.
Typically, there are several levels of risk tolerance ranging from aggressive to conservative. If you fall on the more aggressive side of the risk tolerance range, you may prefer not to adjust your portfolio to a more defensive allocation. Instead, you may be fully prepared to ride out the decline against the possibility of a sudden and unexpected upturn.
But if your risk tolerance leans toward the conservative side of the scale, you may want to shift to a defensive position as early in the cycle as possible. There's the possibility you might miss out on investment gains when the growth cycle resumes. But given that bull markets last longer than bear markets, you can still score impressive gains even by getting back into growth assets a little later in the game. In the meantime, you’ll avoid the kind of deep losses that cause more conservative investors to lose sleep at night.
Some Examples of Defensive Investment Strategies
A defensive investment strategy involves moving to more conservative asset allocations in your portfolio. We’ve already discussed dividend-paying stocks and bonds, which are the staples of defensive investing. But you can also increase your cash holdings. Though you won’t earn much interest on cash, it will protect your principal and provide you with the liquidity you’ll need to get back into growth assets when the market begins to recover.
You may want to add a position in the NOBL fund for a more defensive allocation. Even though it’s down a bit year-to-date, the companies in the fund are among the best established in the country, pay healthy dividends, and are likely to participate in the next market upturn.
You can also consider adding positions in specific stock sectors with a history of weathering bear markets. Utilities and healthcare stocks are prime examples. But with consistent supply chain issues and the ongoing war in Ukraine, energy might be another sector worth considering.
On the bond side, it may be best to stay short-term. Interest rates have been rising, and it looks like that trend will continue for the foreseeable future. If that’s the case, long-term bonds could be money losers. That’s because long-term bonds have an inverse relationship with interest rates: when interest rates rise, bond prices fall.
Instead, you could choose to stay in short/intermediate bonds. You can do that through a fund like the Schwab 1 – 5 Year Corporate Bond ETF (SCHJ). Though it has lost a bit since the beginning of the year, the current dividend yield is just over 3%. If interest rates continue to rise, it’s likely the yield on the fund will go up with it.
How Much of Your Assets Should Be in Defensive Investments
Your defensive allocations should be consistent with your risk tolerance and your assessment of the market's direction in the coming year.
If your risk tolerance is conservative and you believe the market decline will continue for the foreseeable future, your defensive allocation may need to represent most of your portfolio.
But if you're moderately aggressive and believe the market may turn at any time, you may want to restrict defensive positions to no more than 20% or 30% of your portfolio. That will reduce the risk of major declines while keeping you invested in growth assets for the anticipated market upturn.
Easy Ways of Transitioning Into Defensive Investments
Transitioning into defensive investments doesn’t need a radical liquidation of your current portfolio to reorganize it entirely; the process can take place gradually. For example, you can only invest new cash in defensive investments. You can also allocate interest and dividend income in the same way.
Alternatively, if you have asset classes that are performing especially poorly and are expected to continue, you may want to liquidate those positions. You can do it either partially or entirely, then move the funds into defensive allocations.
If your portfolio has had the benefit of steady growth in the past, you might want to avoid doing anything too radical. Since you can't predict which direction the stock market will go, it’s important to ensure that some of your capital is in traditional growth assets. That way, you can participate in a sudden market upturn with at least part of your portfolio.
Should You Adopt a Defensive Strategy?
Carefully evaluate your risk tolerance, where the market has been in recent months, and where you expect it to go in the near future. No one can make that decision for you, so you’ll need to spend some time considering the possibilities.
Even once you become more defensive, it’s important to be flexible. Market turns can be so gradual that they don’t get noticed for months. And by then, the market may have made a significant move – up or down. Be alert to changes in the market, as well as events in the news.
For example, if the Federal Reserve begins to relax interest-rate increases and energy prices drop, it could signal markets are about to turn. You should be prepared to move money back into growth investments and a more aggressive portfolio once again.
Like any other investment strategy, defensive investments aren't guaranteed to work — so don’t expect miracles. Investing has always been a balancing act, and it's impossible to anticipate the right moves all the time.