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Defensive Investment Strategy

Not so much of a risk taker? Not a problem. A defensive investment strategy is designed for investors as such. Learn how to minimize the risk of your portfolio below.
Hristina Nikolovska
Author: 
Hristina Nikolovska
Muze Hasan
Editor: 
Muze Hasan
7 mins
January 15th, 2024
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Defensive Investment Strategy

Investments do bring profitable returns to investors, but these are associated with some form of risk that may incur losses to investments. A defensive investment strategy saves investors by minimizing these losses and rebalancing the portfolio.

The term defensive investment strategy refers to the building of a portfolio that attempts to minimize the risk of losing principal. Typically, a larger portion of a defensive portfolio's funds is allocated to fixed-income securities than equities.

In this article, we will explore the meaning of defensive investment strategy, its pros and cons, defensive investment types, and more.

Understanding Defensive Investment Strategies

A defensive strategy is a portfolio allocation that is willing to give up higher returns in exchange for reduced risk. This type of portfolio is well suited to individuals with low-risk tolerance scores.

Typically, a larger percentage of the asset's funds will be allocated to fixed-income securities, such as bonds, and a smaller percentage allocated to equities, such as common stocks. The primary objective of a defensive investment strategy is the preservation of capital.

As is the case with other strategies, a defensive portfolio requires rebalancing to maintain the desired asset allocation. The portfolio will not only contain investment quality bonds of long and short-term duration but also a number of large-cap stocks.

The entire portfolio will also be spread across a number of industries to reduce risk through diversification.

Pros and Cons of Defensive Investing

Pros
  • Capital preservation during market downturns
  • Lower volatility and protection against economic uncertainties
  • Potential for more stable and predictable returns
  • Focus on long-term wealth accumulation and financial security
Cons
  • Moderate growth potential compared to aggressive investment strategies
  • Potential to miss out on short-term market gains
  • Possibility of underperforming during strong bull markets
  • Need for careful portfolio management to ensure diversification and balance

The Aspects of Defensive Investing

Typically, there are two main types of defensive investors:

  • Investors nearing retirement – At the latter stages of life, preserving the already created wealth is much more important than building wealth.

  • Investors expecting a downturn – Prioritizing capital preservation and mitigating potential losses becomes a priority when anticipating a market decline.

Here’s a rundown of the fundamentals of defensive investing.

Diversification

Creating a well-rounded portfolio with a diverse set of securities is important for almost all investment approaches, and that includes defensive investing.

Spreading your capital across different investment types in different sectors and regions can not only help reduce risks but also increase the potential for stable returns.

Preserving capital is indeed one of the main aspects of defensive investing, but it's equally crucial to generate returns that can outpace inflation.

By diversifying their portfolio, defensive investors can strike a balance between minimizing risks and generating a stable income from multiple sources that can hedge against inflation and ensure the wealth maintains its value.

However, merely allocating your capital across a diversified portfolio is not sufficient for long-term financial success. It’s essential to actively manage your portfolio to adapt to changing market conditions and optimize your investment returns.

Active Management

Active portfolio management involves regularly monitoring your investments, assessing their performance, and making necessary adjustments. This may include rebalancing your portfolio to maintain the desired asset allocation, identifying opportunities for growth, and strategically reallocating your investments based on market trends and economic indicators.

Over time, the performance of different asset classes or investments within a portfolio can vary, leading to a deviation from the original target asset allocation. By rebalancing the portfolio, investors can bring their asset allocation back in line with their original investment objectives and risk tolerance.

In addition, most defensive investors rely on stop-loss orders to minimize the potential for significant losses. Stop loss orders are a risk management tool that allows investors to set a predetermined price at which they will automatically sell a security to limit their losses.

Overall, taking a proactive approach helps investors maintain their desired risk levels and preserve capital, even in volatile market conditions.

How Does a Defensive Portfolio Look Like?

The main thing investors need to understand about defensive investing strategies is that even though they primarily aim to preserve capital, they can be quite lucrative when executed successfully. As long as losses are kept to a minimum, relatively modest returns can accumulate into substantial wealth over time.

The key to achieving substantial growth with fair returns is compound interest. By consistently generating modest returns and reinvesting them, the compounding effect starts to take hold. Each return earned becomes an additional source of potential earnings, contributing to the overall growth of the investment.

For example, let’s say that you invest $5,000 and are able to maintain an annual return of no more than 5%. With a 5% return in the first year, your investment would only yield $250 (5% of $5,000).

If you continue to reinvest your yields and maintain the same annual return over the course of ten years, your investment would grow to approximately $6,381.47. This growth is due to the compounding effect, where each year's return is added to the initial investment, leading to incremental growth over time.

Looking further, in 20 years, your investment would reach approximately $10,366.93. Despite the relatively low annual return of 5%, compounding enables your investment to more than double in two decades.

Note that this is only a hypothetical example illustrating the power of compounding and why it’s such an essential element of defensive investing. In reality, there are many other factors that can impact investment returns and individual investment performance.

Defensive Investment Types

There are several different asset classes that defensive investors can look into to create diversified portfolios. Here’s a quick overview of the most popular ones.

Stocks

Commonly associated with high risk and capital appreciation, stocks are a vital component of many aggressive investment portfolios. However, some specific types of stocks, like dividend-paying, blue-chip stocks belonging to well-established, financially stable companies, are ideal for defensive investors. Their stable performance can provide investors with reliable cash flow and help them balance income generation and capital preservation.

Treasuries

Treasury securities, such as bonds, bills, and notes, are considered one of the safest investments available and are highly sought after by defensive investors.

They offer a fixed interest rate and are backed by the government, making them less risky. Their stability and predictable income make them an attractive choice for defensive investors looking to preserve capital and generate income.

Cash

Cash, or cash equivalents, refers to holding money in liquid form or highly liquid assets such as money market funds. While it may not offer significant returns, keeping a portion of the portfolio in cash is a defensive strategy that provides liquidity and acts as a cushion during market downturns. It’s a stable and readily accessible asset, providing a sense of security and flexibility for defensive investors.

Gold

Gold is a defensive investment known for its role as a “store of value” and hedge against inflation. Its value is often uncorrelated with other asset classes, making it a diversification tool for defensive investors.

While gold doesn't generate income like stocks or bonds, it can act as a safe haven during times of market turbulence and provide a sense of stability to a defensive investment strategy.

ETFs

ETFs are investment vehicles that pool together a collection of assets, such as stocks, bonds, or commodities, and trade on stock exchanges like individual stocks.

Because they represent a basket of multiple underlying assets, ETFs provide more diversification than individual stocks, making them less risky and suitable for defensive investors.

Low-volatility ETFs that focus on stable, low-risk assets are a particularly popular choice among defensive investors.

Defensive Sectors

Defensive investors often prioritize stable sectors like utilities, consumer staples, healthcare, and telecommunications.

These sectors offer essential products and services, making them resilient during economic downturns. Investing in defensive sectors provides a conservative approach with lower volatility, the potential for consistent dividends, and long-term stability for investors seeking capital preservation.

Defensive Investing Strategies

Being successful at defensive investing involves implementing various strategies and considerations to protect your portfolio during market downturns. Here are some key steps to consider when developing a defensive investing strategy:

  1. Define your risk tolerance – Assess your risk tolerance based on your investment goals, time horizon, and ability to withstand market volatility.

  2. Focus on quality – Emphasize investing in companies with strong balance sheets and solid performance track records.

  3. Diversify your portfolio – Spread investments across various asset classes, including defensive stocks, bonds, and cash. Focus on defensive sectors such as utilities, consumer staples, and healthcare.

  4. Consider dividend-paying stocks – Include dividend-bearing stocks with a history of consistent payments and sustainable yields.

  5. Incorporate fixed-income investments – Include fixed-income investments like government bonds or highly rated corporate bonds in your portfolio. Adjust bond duration and yield based on risk appetite and interest rate environment.

  6. Rebalance your portfolio – Monitor your performance and periodically adjust to maintain your desired asset allocation. Sell overperforming assets and allocate funds to underperforming or defensive assets.

  7. Use stop-loss orders – Set stop-loss orders to protect against sudden declines in stock value. Be mindful of execution delays and adjust stop-loss levels accordingly.

  8. Maintain a cash cushion – Hold a portion of your portfolio in cash or cash equivalents to seize investment opportunities during market downturns.

Finally, staying informed about market trends, economic indicators, and relevant news is crucial for a successful defensive investing strategy. Regularly update your portfolio based on changing market conditions and adjust your strategy accordingly.

FAQ

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Contributors

Hristina Nikolovska
Hristina Nikolovska, a graduate of the University of Lodz, is a skilled finance writer for MoneyZine.com. With a knack for simplifying intricate financial topics, her articles provide readers with clear and actionable insights.
Muze Hasan
Muze is an experienced technical writer with vast cross-industry experience writing for Blockchain, Cryptocurrency, NFT, and Metaverse. He has written 100+ whitepapers, launched 10+ projects that have raised more than $30M in capital.
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