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Seeking shelter in volatile markets

Key takeaways

  • Conservative stocks, including stocks with relatively low volatility or high quality, and investment-grade bonds have historically seen smaller losses during down markets than lower quality stocks or bonds.
  • Incorporating securities with these characteristics into a portfolio may potentially mean smaller price drops in down markets but more muted gains in up markets.
  • Such defensive portfolios may reduce losses in a down market but won't eliminate them.
  • A more traditional total return portfolio, which seeks to maximize return for a given level or risk, has historically outperformed the defensive approach modestly over the long term but with sharper ups and downs.

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.

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"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

Data source*: Fidelity Investments and Morningstar Inc, 2022 (1926-2022). Past performance is no guarantee of future results. Returns include the reinvestment of dividends and other earnings. This chart is for illustrative purposes only. It is not possible to invest directly in an index. This chart is not intended to represent the actual or future performance of any investment option or strategy. Time periods for best and worst returns are based on calendar year. For information on the indexes used to construct this table, see Data Source in the notes below. The purpose of the target asset mixes is to show how target asset mixes may be created with different risk and return characteristics to help meet an investor’s goals. You should choose your own investments based on your particular objectives and situation. Be sure to review your decisions periodically to make sure they are still consistent with your goals.

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

The data in the chart is described in the text.
In this scenario, "your losses" refers to the value of your portfolio. For illustration only; not indicative of any investment outcome. Source: Fidelity Investments.

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.

The data in the chart is described in the text.
For illustration only.

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."

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* Data Source: Fidelity Investments and Morningstar Inc. Hypothetical value of assets held in untaxed portfolios invested in US stocks, foreign stocks, bonds, or short-term investments. Stocks, foreign stocks, bonds, and short-term investments are represented by total returns of the IA SBBI US Large Stock TR USD Ext 1/1926-1/1987, Dow Jones Total Market from 2/1987-12/2020; IA SBBI US Large Stock TR USD Ext 1/1926-12/1969, MSCI EAFE 1/1970-11/2000, MSCI ACWI Ex USA GR USD 12/2000-12/2020; US Intermediate -Term Government Bond Index from 1/1926 - 12/1975, Barclays Aggregate Bond from 1/1976 - 12/2020; and IA SBBI US 30-Day T-Bills from 1/1926 to 12/2020. Past performance is no guarantee of future results. The purpose of the target asset mixes is to show how target asset mixes may be created with different risk and return characteristics to help meet an investor's goals. You should choose your own investments based on your particular objectives and situation. Be sure to review your decisions periodically to make sure they are still consistent with your goals.

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.

Views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.

As with all your investments through Fidelity, you must make your own determination whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and evaluation of the security. Fidelity is not recommending or endorsing this investment by making it available to its customers.

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.

Past performance is no guarantee of future results. Diversification and/or asset allocation do not ensure a profit or protect against a loss. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.

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. Lower-quality fixed income securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Foreign investments involve greater risks than U.S. investments, and can decline significantly in response to adverse issuer, political, regulatory, market, and economic risks. Any fixed-income security sold or redeemed prior to maturity may be subject to loss.

Including high quality bonds and conservative stocks in a defensive investment approach may help reduce volatility in your diversified portfolio, providing a smoother overall investment experience, and may help keep you on track to reach your long term goals. High quality bonds may generate positive returns during equity downturns. Intermediate-term US treasuries, an example of high quality bonds, tend to move in the opposite direction than stocks during significant and sustained stock market declines. When stocks fall sharply and trend lower, US Treasuries often rise. High quality bonds can help offset stock declines within a diversified portfolio. Conservative stocks tend to display a smaller degree of price movement than the broader stock market. Minimum volatility stocks, an example of conservative stocks, tend to be associated with companies that have relatively stable businesses. Historically, minimum volatility stocks hold up better when the broader stock market falls. During up markets, when broader stock market returns rise sharply, minimum volatility stocks also tend to rise, but more modestly than the broader stock market.

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