If you invest, you have to plan for risk. Some investors find market volatility exciting, but for most of us, facing dips in the value of our savings can cause anxiety at best, or worse, drive us to make panic-driven mistakes.
There are defensive approaches you can take to help reduce the impact of down markets on your portfolio, while still trying to capture some of the growth potential offered by investing. But, like most choices, if you try to play defense, you have to face some tradeoffs.
"A defensive investment approach attempts to reduce the impact of falling markets on an investor," says Callum Henderson, portfolio manager who works on defensive strategies within Fidelity's Portfolio Advisory Services. "But there is no free lunch—defensive portfolios aim to limit losses in a down market but will typically trail in a strong up market. Over longer time periods, a defensive portfolio aims to capture much of the growth of the market, but with a smoother ride."
Going beyond asset allocation
One of the best ways investors can manage risk is by choosing a mix of stocks, bonds, and cash based on their goals, how long they plan to invest, their financial situation, and feelings about risk. Trying to choose a mix that seeks to efficiently get the most return for a given level of risk is called a total return portfolio. Historically, portfolios that are made up of more stocks have had higher average returns, but also suffered bigger losses during down markets.
Choose the amount of risk you are comfortable with
So, your mix of stocks, bonds, and cash is the first step in helping to manage risk. If you are uncomfortable with the amount of risk in your portfolio, you could move to a more conservative portfolio—with a larger proportion of bonds. Historically, a more bond-heavy portfolio has had smaller losses in down markets. But it has also experienced smaller gains overall. Another option would be to try to change your pattern of returns, meaning you try to achieve similar or slightly lower returns over the long term, but with smaller drops and gains—essentially looking for a smoother ride. That's where a defensive portfolio comes in. Defensive portfolios go a step beyond asset allocation, to look for stocks and bonds with specific characteristics that might be able to try to help reduce the volatility of your returns.
Playing defense: Seeking lower highs, higher lows, and similar performance over a market cycle
Making a portfolio defensive
There are a number of ways to make a portfolio more defensive. One technique is to target stocks with lower levels of historic volatility or higher quality. Some companies, due to industry, competitive position, or strong financials, have records of lower volatility in down markets. Targeting those stocks can help to limit downside risk during selloffs.
Similarly, within a bond portfolio, a fund manager might select securities that can offer protection from specific risks that seem relevant for a given market environment—for instance, in a higher inflation environment, Treasury inflation-protected securities (TIPS) might help protect the value of a fixed income portfolio. In a low-growth, low-inflation environment, a mix of investment-grade bonds might offer protection from credit risk—the risk that a corporate bond issuer will run into financial problems and be unable to honor its commitment.
You should choose your own investments based on your particular objectives and situation. Remember, you may change how your account is invested. Be sure to review your investments decisions periodically to make sure they are still consistent with your goals.
The bottom line
Portfolio construction offers lots of potential for investors who are looking to manage risk. A basic option is to adjust your asset mix, but defensive portfolios go a step further, by targeting specific securities with characteristics that have the potential to help smooth out investment potential. Investors interested in defensive portfolios have a range of options, including managed accounts, ETFs, and mutual funds.
Bear in mind that a defensive portfolio won't eliminate day-to-day dips in the market: It's designed to help reduce losses in more severe down markets, without giving up much in terms of long-term performance potential.
"Investing offers a powerful tool for wealth creation, and can help you meet your goals," says Henderson. "But to capture that potential, you need to be able to live with your portfolio. If you are nervous about the markets, a defensive investment portfolio might help you be able to stick with your plan despite rocky markets."