It’s often said that managing risk is as important as getting good investment returns. Ownership of defensive investments can offset potential losses from other investments while smoothing out returns.
Treasury bonds, T bills, gold, money market funds, put options, TIPS, and inverse ETF’s are all examples of defensive investments. These are all assets that tend to increase or maintain their value during financial threats as high inflation, recessions, Black Swans, and bear markets.
In this post, I’ll share important facts about defensive investments that every investor will want to know. We’ll cover several types of defensive investments, how and why most people already own defensive investments, time considerations for holding defensive investments, and why bonds are not always the best defensive investment as many investors believe.
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Types of Defensive Investments
There’s a lot of information available about defensive stocks. There are, however, often overlooked defensive investments besides stocks.
In fact, different types of defensive investments protect investors from different threats. This means that one defensive investment may not protect against high inflation, but it will protect an investor’s portfolio during bear markets, for example.
|Defensive Investment||Common Defense|
|Defensive Stocks||Bear Markets (Partial)|
|Anamoly Defensive Investments||Various|
|Alternative Income Generating Assets||Bear Markets, Inflation|
|Cash||Bear Markets, Crisis|
|Short Term Notes||Bear Markets|
Here are some of the different types of defensive investments and when they help lower investment risk.
Are Stocks Defensive Investments?
While some stocks are defensive investments, most stocks are not. Slowing economic growth is a drain on company earnings. Also, since most stocks tend to move with the overall market, the downward movements during bear markets pull most stocks down with it.
On the other hand, some companies thrive during recessions, often making their stocks good defensive investments which can help reduce risk within a stock portfolio itself. Examples of such defensive stocks are below.
Examples of Defensive Stocks
The type of business a company conducts influences just how defensive the company’s stocks are as an investment. Some businesses are more resistant to economic cycles than others, while other businesses can actually thrive during recessions.
Stocks that perform well no matter what the economy is doing tend to be more defensive investments than stocks that depend on a growing economy.
1. High and Low End Stores
For example, a mid range clothing store may struggle during a recession making its’ stock less defensive. This is because high net worth consumers continue to purchase luxury and high end items because their spending habits are less affected by economic downturns. During hard times, however, mid range consumers purchase lower priced products. This supports companies at the high end and the low end of prices, making their stocks more defensive investments than companies providing mid range goods.
2. Sellers and Producers of Alcohol
Another example of defensive stock investments is those of companies in the alcohol sector since people drink more to seemingly ease their suffering during bad economic times.
3. Auto Repairs
More people repair their cars instead of buying new ones, making auto parts suppliers good defensive stocks.
4. Companies That Sell Necessities
Stocks in consumer staple companies selling necessities that consumers buy no matter what, like toothpaste or toilet paper, tend to be good defensive investments.
Stocks in utility and pharmaceutical companies provide more good examples of defensive stocks given the necessity for their products. (My Dad used to tell me “The last thing to go out are the lights” when explaining his affinity for utilities and municipal bonds back in the early 1980s.)
So companies that see profits rise during recessions can see their stocks increase in value accordingly, making many of these types of companies truly defensive investments simply by the nature of their business.
Of course, black swans, disruptors (like the internet), and secular changes in consumer spending habits can all affect the stocks that were previously considered defensive. I recall seeing this happens with quality high end retailers.
There are many additional variables that can cause a company’s stock to suffer, and the worst seems to surface during bad financial times. For example, companies can have management issues, competitive threats, problems from political change, and various scandals that can ruin an otherwise normally ideal defensive investment.
Are Dividend Stocks Defensive Investments?
Given that most dividend stocks continue paying out income even during declining stock markets, they tend to be somewhat defensive investments more so than the stocks of growth oriented companies.
Companies paying dividends are also generally more stable companies because they have been through years of growth; this safety factor makes their stocks more defensive investments than companies that have not achieved a level of earnings congruent with paying out shareholder dividends.
Anomaly Defensive Stock Investments
There are some investments that turn out to be defensive, but you couldn’t have predicted it beforehand.
For example, Zoom Video Communications (ZM) soared during the early 2020 bear market. Video conferencing became an absolute necessity during the shutdown for those working from home, which was almost everyone.
Sure, we all knew video conferencing while working from home was a trend, but how could we have known that it would suddenly become a necessity worldwide by the masses?
As such, Zoom’s stock soared as the rest of the stock market fell.
Are Bonds a Good Defensive Investment?
Bonds are known to be defensive investments. Again, they are the staple defensive asset in most asset allocation based portfolios, which are the core of traditional buy and hold investment accounts.
Watch my video Do Bonds Go Up During Bear Markets for more detail on how often bonds have acted as a defensive investment.
Risks of Bonds as a Defensive Asset
As you saw in my video above, it’s true that high quality and Treasury bonds tend to rise during most bear markets. Bonds, however, have risks, too.
- Interest Rate Risk
- Credit Risk
- Inflation Risk
Each of these risks for this staple defensive investment is explained more below.
Interest Rate Risk
While the Federal Reserve tends to keep interest rates low during recessions in an attempt to revive the economy, it’s important to remember that bonds go down in value when interest rates rise.
Sometimes investors are caught off guard when rates rise unexpectedly when they thought they had a defensive investment in quality bonds.
During bad financial times, companies go bankrupt. While bond investors have a right to capital before common stockholders during bankruptcy, the reality is that sometimes companies default on their bonds.
This is one reason that, thus far, U.S. Treasury bonds have been considered the most defensive investment by many.
Bonds have fixed interest rates. Inflation depletes the income from bonds.
For example, if an investor earns 2% income from owning a bond fund, and the real inflation rate is 3%, the investor has an after inflation yield of -1%.
The value of the bonds also gets depleted from annual inflation.
During long periods of low inflation, it’s easy to forget that inflation was 11.3% in 1979 and then 13.5% in 1980.
Just imagine if you had bought bonds as a defensive investment in 1972 when inflation was a tame 3.3%. They simply would have not done their job as a defensive investment.
As you’ll see, like other defensive strategies here, bonds are not defensive for all kinds of risks, but they tend to work well during stock bear markets. This is explained more in my post What Are the Risks of Bonds?
Holding Gold as a Defensive Investment
During times of economic uncertainty, investors flock to gold, thereby driving up the price of gold stocks and gold ETF’s.
Is Gold a Good Defensive Investment?
Gold performance has a negative skew except during major financial meltdowns making it one of the more reliable defensive investments.
Fortunately, financial meltdowns are rare, at least they have been in the U.S.
There are, however, many dynamics that affect the price of gold, including supply and demand, making it challenging for most investors to profit from gold stocks long term.
Gold and Inflation
Gold is commonly thought to be a defensive investment against inflation risk, but history shows this has not always been the case as you can see from the chart below.
Inflation and Gold Chart Source: InflationData.com
Below is my video entitled Does Gold Go Up When Stocks Go Down for more information on gold performance in past bear markets.
Inflation is a risk every bit as real as recessions and bear markets. TIPS are a type of bond designed specifically to protect investment portfolios from high inflation. This makes TIPS an ideal defensive investment against inflation.
Because inflation is an invisible threat, we often overlook that we need defense against it.
In the video below, I give an example of how much inflation affects spending power.
Income Generating Assets as Defensive Investments
We all know that investors invest primarily for growth or income.
During bear markets, when growth isn’t happening, income is still being paid out to investors. This means that investments that pay income always have something to offer. This dynamic naturally makes income generating assets defensive investments.
Examples of this dynamic are seen in dividend paying stocks as addressed earlier.
Defensive Alternative Investments
Dividend stocks and bonds aren’t the only defensive investments that earn their defensive stance from the income they generate; real estate rental properties and small business ownership or investments which generate income can also be excellent defensive investments.
Note that alternative assets, such as real estate rentals and small business investments are not commonly seen on a list of defensive investments since they aren’t considered traditional investments. These two income generating assets are increasingly gaining popularity as defensive investments, however.
From my own experience, which I write about here at Retire Certain, both real estate rental properties and online business investments are two of my favorite defensive investments. They are an excellent enhancement to my defensive ETF portfolio in that they provide further diversification as well as consistent income.
For example, during the 2008 financial crisis, the 2020 bear market, and the national shutdown, rent checks from our properties kept coming in.
And during the 2020 bear market, income rose in our online financial coaching programs and web properties because people had more time, and perhaps, saw the importance of improving their investing skills.
This confirmed for us, once again, the importance of diversification among defensive investments, even with investments that require more effort.
Read my related post How to Make Money When Stocks Drop.
Alternative Investments as Inflation Defense
In addition to ongoing income, real estate and many small businesses can also be good defensive investments during rising inflation, which occurs almost every single year, depleting investors’ dollars like a thief in the night.
Read my related post How to Account for Inflation in Retirement.
High Levels of Cash or Short Term Notes
Higher levels of money market funds (cash) is one of the easiest defensive investments. While I love the seeming security of money market funds, they aren’t without problems.
First, too much cash hurts investment returns.
Second, and sadly, often inflation leaves investors with negative real returns, particularly in recent years.
Offensive Vs Defensive Investments
Should investors always own defensive investments, or try to decipher when to add defensive investments to a portfolio?
In the 1990’s I learned the hard way that offensive and defense investments perform differently based on factors other than security selection. After a few years, I grew impatient and rotated from some excellent value focused (defensive) stock mutual funds to growth focus (offensive) stock mutual funds based on performance.
The performance lag in the mutual funds was due to economic factors.
Just like in football, with investing, there are times to own more defensive investments, and there are times to own more offensive investments.
With offensive investments, investors are more focused on getting gains, but with defensive investments, investors are more focused on not losing money.
Offensive investment strategies perform better during times of economic expansion while defensive investment strategies perform better during economic contraction or bear markets.
Much like the coach who must decide whether to play defensive vs offensive, the skill for us investors is the same when it comes to structuring our portfolios.
Evaluating Offensive Vs Defensive Investment Portfolios
It seems logical that defensive investments perform better during recessions and bear markets than offensive investments.
Yet, even when we know this, it’s easy for us investors to get caught off guard by this reality, which is confirmed by past investment returns, during both bull and bear markets, and here’s why.
When evaluating investment performance, we are naturally lured toward the ___________________ (you fill in the blank: portfolios, stocks, strategies, wealth managers, funds, etc) with the best performance.
When evaluating past investment performance after a long bull market, offensive strategies naturally show the best performance. As investors, we’re tempted to chase the best returns even at a time when defensive investments may be the best choice.
And when evaluating past investment performance after a bear market, defensive strategies show the best performance. This is when investors tend to flock toward defensive investments.
But we can overcome this risky habit; logically, by simply considering what the economy and overall stock market did during any given time frame we can avoid this bias when evaluating a defensive investment portfolio.
Recency Bias and Investing
This sounds easy enough, right?
It is, except that something in “behavioral finance” called “recency bias” causes us to think that what’s happened lately will continue happening. This bias leads us to forget to factor how the overall economy and markets performed in the period we’re evaluating.
Because our emotions naturally affect how we think and invest.
Overly Optimistic Expectations
We all love to hope for the best possible outcome. We want to hear that our investment portfolio will make ____ (again, you fill in the blank: 5%,8% 10%) a year and we’ll have plenty of money to retire happily.
Overly Pessimistic Expectations
On the other hand, we are often gripped by fear after bear markets and bad financial times.
For this reason, I hold fast to my claim that history, logic, and math are the best investment evaluation tools. This approach tends to lead me toward the best investments for the right reasons.
There is an easier way.
The alternative to trying to invest defensively or offensively as needed is to hold a defensive portfolio with both offensive and defensive investments that are non-correlated during various economic happenings.
What Is a Defensive Portfolio?
A defensive portfolio is one that is structured with at least some defensive investments:
- With lower than normal risk
- To capitalize on assets that increase in value during bad financial times
This can always be done with fixed percentage allocations between offensive and defensive investments, or portfolios can be modified as changes in the economic environment warrant.
For example, more proactive investors adapt to higher levels of cash or bonds when they are investing defensively as opposed to holding higher levels of growth type of investments when they are investing offensively.
How Do You Build a Defensive Portfolio?
Now you’ve seen the types of defensive investments, know about investing offensively vs defensively, and when it makes sense to do so.
You may be wondering how to build a defensive portfolio.
Many investors don’t realize that they already have a somewhat defensive investment portfolio if they use the popular buy and hold asset allocation model.
As you may have already read here, the most popular investment strategy is simply “buy and hold” investing into stocks and bonds based on an asset allocation model for your age and desired risk.
This is explained more in my post How to Understand Your Investments.
Buy and Hold Investing with Both Offensive and Defensive Investments
This investing method is wildly popular for the reasons below, including built in defensive investments.
- High quality bonds act as defensive investments during most bear markets
- Most investors like a portfolio that doesn’t have to be adapted for economic cycles
- It is hard to time economic and related bear market cycles
- The buy and hold strategy is heavily promoted in the press as being the best investment strategy for the reasons above
- This somewhat defensive strategy can be easily implemented by both individuals and financial advisors
This means that most traditional buy and hold asset allocation type investors already have a somewhat defensive portfolio simply because they own at least some high quality bonds.
Watch my video below if you want to know more about this popular beginner investing strategy that has at least one defensive investment.
Investing is never that simple, however, at least not for all economic conditions and portfolio threats. The truth is that bonds, the defensive investment in most buy and hold portfolios, are not without risk as outlined earlier.
Bonds also ended a forty year bull market as interest rates declined to unprecedented lows from the early 1980’s through 2020. This long term bond cycle leads me to questions bonds as the ultimate defensive investment.
Read my related post Are Stocks Safe for Retirement?
A Popular Defensive Portfolio
Investors can easily build a defensive portfolio that goes beyond simply the popular buy and hold stocks and bonds with one of the most publicized defensive portfolios, the All Weather Portfolio developed by billionaire Ray Dalio for his family’s wealth.
This portfolio holds gold and has a high allocations in bonds. While this is considered the best defensive portfolio by many, it’s important to note that, moving forward, the high bond holding does cause some concern for the reasons given above.
You can read all about this defensive portfolio in my post All Weather Portfolio – Pros and Cons.
Defensive ETF Portfolio
It is important to note that I do no longer hold a fixed asset allocation portfolio of both offensive and defensive investments. Instead, I invest proactively by using an ETF asset allocation model that rotates among both offensive and defensive investments based on changing economic conditions and financial markets, investing in potential opportunities that present themselves as a result of ever changing conditions.
Now you have seen the types of defensive assets and other factors to consider in building a defensive portfolio.
The best type of defensive investment for you depends on what kind of investor you want to be, your acceptable risk tolerance, and what type of risk protection you’re seeking.
My Ultimate Wealth Plan outlines the 17 kinds of risk with strategies to lower each type. You can get it here now.