Proactive investors buy defensive investments to manage risk, particularly as financial markets become less stable or overvalued.
What are defensive investments? Defensive investments are assets that tend to increase or maintain their value during financial threats such as high inflation, recessions, Black Swans, and bear markets. Defensive stocks, Treasury bonds, T bills, gold, money market funds, puts and inverse ETF’s are examples of defensive investments.
In this post, I’ll share more about defensive investments, address 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.
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.
Stocks that perform well no matter what the economy is doing tend to be more defensive than stocks that depend on a growing economy.
Defensive stocks, then, can help reduce risk within a stock portfolio itself.
Examples of Defensive Stocks
The type of business a company conducts influences just how defensive the company’s stocks are. Some businesses are more resistant to economic cycles than others, while other businesses can actually thrive during recessions.
For example, a mid range clothing store may struggle during a recession. On the other hand, consumer staple companies that sell necessities which consumers buy no matter what, like toothpaste or toilet paper, are more defensive than the clothing store.
Utility, pharmaceutical, auto repair and alcoholic beverage companies are more good examples of companies with defensive stocks. (My Dad used to tell me “The last thing to go out are the lights” when explaining his affinity for utilities and municipal bonds to me back in the early 1980’s.)
As explained more later in this post, dividend stocks tend to hold up better during bear markets than the stocks of growth oriented companies.
Are These Stocks Always Defensive?
It’s important to note that, based on estimates, about 75% of all stocks move with the overall market. This means the overall market tends to pull dividend stocks down with it during bear markets, albeit less so than growth stocks.
On the other hand, some companies thrive during recessions, often making their stocks good defensive investments.
Alcohol sales rise because people drink more to seemingly ease their suffering. More people repair their cars instead of buying new ones. 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.
Other Factors Affect How Defensive a Stock Is
There are, however, other factors that can hamper how much protection defensive stocks can offer investors, as you’ll see in this example.
In the past, both high end and low end retailers have held up well during recessions. This is because the very wealthy continue to spend at their favorite high end stores.
On the other hand, stores with low priced products do well because they often sell necessities. Plus, the mid-range spenders lower their purchasing habits to cheaper products found at the dollar stores.
But other factors can come into play that make buying high and low end stocks less effective defensive investments.
For example, after decades of success, many high end retailer’s profits have suffered greatly in recent years from online shopping. This spending habit change led to the demise of high end retailer Neiman Marcus in the 2020 recession.
Black swans (like the internet), disruptors, and secular changes in consumer spending habits can all affect the stocks that were previously considered defensive, such as 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.
In summary, yes, there are some stocks can be good defensive investments, but their dependability as a defensive strategy is not fail proof.
Treasury bonds are the most common defensive investment, as explained in more detail later in this post.
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?
Watch my video Do Bonds Go Up During Bear Markets for more detail on how often bonds have acted as a defensive investments.
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 good defense against inflation risk, but history shows this has not always been the case.
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 bonds are a way to protect investment portfolios from high 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.
Anomaly Defensive 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 had become 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.
Income Generating Assets
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 them more defensive.
Examples of this are seen in both dividend paying stocks as mentioned earlier.
Defensive Alternative Investments
Dividend stocks and bonds aren’t the only 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 defensive investments.
Note that alternative assets, such as real estate rentals and small business are not something you’ll commonly see on a list of defensive investments since they are outside most investor’s portfolios. These two, however, come from my own experience, which I write about here are Retire Certain.
For example, during the 2008 financial crisis, the 2020 bear market and national shutdown, rent checks kept coming in.
And during the 2020 bear market, income rose in our online financial training 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 when it’s 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 .
REITs and MLPs
REITs and MLPs have been, historically, common income investments that often act defensively during bear markets. They each, however, can have economic and market dynamics that affect their strength as defensive investments.
This was well demonstrated in the 2020 bear market as REITs and MLPs tanked from supply demand issues. Many cut their dividends, which led both of these asset categories to lose their status as reliable income generating investments.
High Levels of Cash or Short Term Notes
Higher levels of money market funds 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, inflation leaves investors with negative real returns.
Offensive Vs Defensive Investments
Should investors always own defensive stocks, invest for growth, or try to decipher which will do better and when?
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. (I wished I had read this article before then, but I didn’t know this at the time:)
Just like in football, with investing, there are times to invest more offensively, and there are times to invest more defensively.
With an offensive portfolio, investors are more focused on gains, but with a defensive portfolio investors are more focused on not losing money.
Offensive investment strategies perform better during times of economic expansion while defensive investment strategies perform better 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, strategies, wealth managers, funds, etc) with the best performance.
When evaluating past investment performance after a long bull market, however, offensive strategies show the best performance.
And when evaluating past investment performance after a bear market, defensive strategies show the best performance.
But we can overcome this. 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 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 it can be modified during the year as needed by more proactive investors.
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
This investing method is wildly popular for the reasons below, including built in defensive investments.
- High quality bonds act as defensive investment 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 quality bonds.
Watch my video below if you want to know more about this popular beginner investing strategy that has at least one defensive asset.
But investing is never that simple, at least not for all economic conditions and portfolio threats. The truth is that bonds, the defensive investment in most buy and hold portfolios, don’t always perform well, so keep reading.
Read my related post Are Stocks Safe for Retirement?
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.
Risks of Bonds as a Defensive Asset
As you saw in my video above, it’s true that high quality bonds tend to rise during most bear markets. Bonds, however, have risks, too, as explained 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 and they thought they had a fail safe investment in quality bonds.
During bad financial times, companies go bankrupt. While bond investors have a right to capital before common stockholders, 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 offsets 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.
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.
One of the most popular defensive portfolios is the All Weather Portfolio developed by billionaire Ray Dalio for his family’s wealth.
This portfolio holds gold and 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.
Now you have seen the types of defensive assets and other factors to consider in building a defensive portfolio.
The best defensive investment type depends on what kind of investor you want to be, how much risk you want, and what type of risk you want to protect your investments from.
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