Every winning team consists of a good offense and a good defense
Like any good sports team, you need both a good defense and a good offense, and the same is true for investing. As an investor you will need to decide which risk you are willing to live with: the fear of losing money or the fear of missing out on an opportunity. This is a tradeoff that we all face when investing our money. We witnessed the fastest drop to a bear market in history early this year, however, since the low on March 23rd the market has rebounded over 30% since then, even with a flood of negative headlines. Many now believe that we will not revisit these lows in the stock market because the bad news that we will see going forward has already been priced in. However, on the other side of the coin maybe the stock market recovered too quickly and is not pricing in the event that this reemerges later on in the year. Since this is uncertain, what can investors do that do not want to stomach another drop in the market? The answer is to first determine what amount of money they need to keep safe, then develop a defensive investment strategy for that money.
A defensive investment strategy is one that aims to minimize loss of principal during a market downtown. A defensive side of your portfolio is one that is to be invested conservatively to protect a portion of your portfolio. This is done through proper asset allocation and a strategy known as rebalancing to maintain those asset allocation percentages. Here are some of the investments to utilize in building a defensive investment strategy, guidelines to how much you should allocate and the best way to execute on these investment decisions.
What are Defensive Investments
High Quality Short Maturity Bonds
The first defensive strategy to look at is short maturity high quality bonds and most specifically United States Treasury bills or notes. These are one of the most common investment vehicles in defensive portfolios and have historically been known to be very safe a conservative providing investors with a relatively small amount of interest while trying to minimize risk. Historically you can buy these from large banks, however today this are made easily accessible in Exchange Traded Funds at brokerage firms.
These stocks tend to be stable investments with a track record of paying an above average dividend. These are companies that have a constant demand for their products and tend to remain stable during different market cycles. They are good for reducing the overall risk of a stock portfolio and still have the potential to deliver a slight higher total return.
The most conservative investment option is cash equivalents. These investments are also referred to as money markets or stable value funds. This is the lowest amount of risk for the lowest amount of expected return. This money should be used for short term liquidity needs.
How much should you allocate to a defensive strategy
Obviously this is a tough question to answer because everyone has different goals, time horizons and willingness to take risks. However, having a good financial plan can be a great starting point for making these decisions. For individuals that are approaching retirement, a good rule of thumb to use for the amount that should be conservatively invested is 3 years worth of living expenses. The thought behind that is that is typically takes a little over 3 years for stocks to return to their previous highs after a bear market. This will ensure someone in retirement or approaching retirement has the money they need and will not be selling their stock positions at a time that is not most advantageous. Another rule of thumb for younger investors may be the rule of 120. To apply this rule you simply subtract 120 minus your current age. The amount you are left with is the amount you can afford to invest in stocks or something more aggressive. The remainder can be used for your defensive bucket of investments.
Implementing a defensive strategy
Throughout the years the barrier for entry to implementing a defensive investment strategy has dropped significantly. This strategy became easier with the emergence of index funds. Index funds track a certain index or sector of investments. The advantage of index funds is they provide broad diversification at a very low cost. Similar to index funds ETF’s have become more and more prevalent in the investment world. ETF’s are passive investments that also track an index or a sector. These two products have made it significantly easier to invest in the bond market. Instead of having to invest in individual bonds or individual stocks an investor can own the index and have broad diversification. The final barrier to entry that was removed was dropping commissions on stocks and ETF trades to 0$. An investor can know open an account for free and trade for free to get their money invested. Determine your defensive bucket is very difficult to navigate for a novice investor. The simple solution would be to put the money into cash, however, this may not be the best use of your money.
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