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Preparing your portfolio for tough markets

Key takeaways

  • By investing defensively, you may be able to implement an approach that could result in shallower dips in your portfolio when the broader market is in decline.
  • A defensive portfolio may seek to include more conservative stock investments, high-quality bonds, and alternative investments that are less correlated to the performance of traditional asset classes.
  • Investors may want to work with a professional who can devote more time and attention to constructing and maintaining a defensive portfolio to help ensure their plan remains on track.

When markets become volatile and recessions loom, one of the biggest threats to your portfolio performance may not be the falling value of your investments—it might be how you react to it.

Over the last 30 years, studies have shown that when investors give up on their long-term strategies and begin reacting to short-term market developments—selling investments as prices fall, for example—portfolio performance suffers.1 While your gut may compel you to sell in order to stanch the bleeding and preserve what's left of your investment, getting out of the market can be potentially devastating to a portfolio, even if it's just for a short time. For example, missing the best 5 days in the market between 1980 and 2022 could have reduced portfolio returns by 38%.2

Staying invested in the face of market turmoil is easier said than done, however. "We've seen lots of evidence that when people experience significant volatility in the markets, they may become emotional and abandon their financial plan," says Scott McAdam, an institutional portfolio manager with Strategic Advisers, LLC, the investment manager for many of our clients who have a managed account. While there are personal habits you can develop to prepare yourself for the emotional distress of watching your portfolio value drop, it may make sense to configure your portfolio in a way that can help mitigate the impact of volatility. By investing defensively, you may be able to implement an approach that could result in shallower dips in your portfolio when the broader market is in decline. And shallower dips may help you fight the urge to overreact and save you from possibly abandoning your plan.

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Looking for stability in an uncertain environment

While diversification is a good first step in crafting a portfolio designed to weather sudden changes in the market, defensive investing takes things a step further by tilting allocations to more conservative areas and incorporating specific asset classes that have historically tended to better absorb volatility. This may help temper losses in down markets while still providing enough risk exposure to allow a portfolio to potentially benefit from gains when the market is in better shape.

Such a portfolio may include:

  • Conservative US and international stocks. According to McAdam, companies with strong balance sheets, steady earnings growth, and historically lower volatility may help temper volatility within a portfolio's stock allocation.
  • High-quality US Treasury bonds. When stocks fall sharply, Treasurys have often risen and may help offset declines in a portfolio. "When markets run into bouts of volatility, US Treasury bonds may act as a safe haven," says McAdam. "They have typically benefitted in such periods, which can sometimes temper what's going on in the market."
  • Treasury Inflation-Protected Securities (TIPS). These are bonds whose principal and interest payments are designed to rise when inflation does.
  • Nontraditional asset classes. Alternative investments, such as hedge funds and derivatives, tend to be less correlated to traditional asset classes, which may provide enhanced diversification opportunities.

Aiming for lower highs, higher lows

The aim of this defensive preparation is a portfolio that offers a narrower range of potential outcomes—less likely to reach the highs of a portfolio focused solely on maximizing return, but also less likely to experience significant volatility.

The Portfolio Advisory Services defensive approach managed by Strategic Advisers, LLC, seeks to outperform the Portfolio Advisory Services total return approach during down markets. (See how these strategies have historically performed in various market conditions.)

Seeking lower highs, higher lows, and similar performance over a market cycle

In this scenario, "your losses" refers to the value of your portfolio. For illustration only; not indicative of any investment outcome. Source: Fidelity Investments.

"A total return strategy," says McAdam, "is going to take on more volatility for a chance at higher returns, whereas a defensive portfolio may give up some amount of returns in exchange for potentially lower volatility." McAdam says that in addition to temperamentally risk-averse investors who are simply looking for some reassurance in a difficult market environment, those who are near or in retirement may also find this strategy appealing given their shorter time horizon.

The power of professional advice

Self-directed investors who lack the time or skill may find it difficult to construct a defensive portfolio themselves, let alone monitor and rebalance it over time, as necessary. Working with a professional who can devote more time and attention to this effort may be worth it.

Strategic Advisers monitors the business cycle and conducts deep research into the various asset classes to identify securities that they believe are well suited for a defensive investment strategy. Additionally, they employ a disciplined process to reallocate funds between asset classes as markets move, in order to help maintain a client's desired asset allocation and to help ensure that the portfolio remains on track. This is especially critical, as the longer an investor goes without rebalancing, the more their risk may inadvertently increase or decrease.

Whatever approach you take, it's important to remember that periods of volatility, and even recessions, have historically tended to be relatively shallow and short-lived when compared to the longer, expansionary periods they interrupt. For prudent investors who maintain a long-term perspective, there very well may be a light at the end of the tunnel.

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More to explore

1. "Dalbar QAIB 2022: Investors are Still Their Own Worst Enemies," Index Fund Advisors, April 4, 2022. 2. Past performance is no guarantee of future results. Based on hypothetical growth of $10,000 invested in the S&P 500 Index 1/1/1980–6/30/2022. Source: FMRCo, Asset Allocation Research Team, as of June 30, 2022.The hypothetical example assumes an investment that tracks the returns of the S&P 500® Index and includes capital gains and dividend reinvestment but does not reflect the impact of taxes, fees, or expenses, which would lower these figures. It is not possible to invest directly in an index. All indexes are unmanaged. "Best days” were determined by ranking the one-day total returns for the S&P 500 Index within this time period and ranking them from highest to lowest. There is volatility in the market and a sale at any point in time could result in a gain or loss. Your own investment experience will differ, including the possibility of losing money.

Investing involves risk, including risk of loss.

Past performance is no guarantee of future results.

Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.

Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.

Foreign markets can be more volatile than U.S. markets due to increased risks of adverse issuer, political, market, or economic developments, all of which are magnified in emerging markets. These risks are particularly significant for investments that focus on a single country or region.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

Fidelity® Wealth Services provides non-discretionary financial planning and discretionary investment management through one or more Portfolio Advisory Services accounts for a fee. Advisory services offered by Fidelity Personal and Workplace Advisors LLC (FPWA), a registered investment adviser. Discretionary portfolio management services provided by Strategic Advisers LLC (Strategic Advisers), a registered investment adviser. Brokerage services provided by Fidelity Brokerage Services LLC (FBS), and custodial and related services provided by National Financial Services LLC (NFS), each a member NYSE and SIPC. FPWA, Strategic Advisers, FBS, and NFS are Fidelity Investments companies.

Alternative investment strategies may not be suitable for all investors and are not intended to be a complete investment program. Alternatives may be relatively illiquid; it may be difficult to determine the current market value of the asset; and there may be limited historical risk and return data. Costs of purchase and sale may be relatively high. A high degree of investment analysis may be required before investing.

Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917