#IM.05 DEFENSIVE INVESTMENT STRATEGY

Updated: Mar 29, 2021

What is a Defensive Investment Strategy?


A defensive investment strategy is a conservative method of portfolio allocation and management aimed at minimizing the risk of losing principal. A defensive investment strategy entails regular portfolio rebalancing to maintain one’s intended asset allocation; buying high-quality, short-maturity bonds and blue-chip stocks; diversifying across both sectors and countries; placing stop loss orders; and holding cash and cash equivalents in down markets. Such strategies are meant to protect investors against significant losses from major market downturns.


Defensive Investment Strategy and Portfolio Management


A defensive investment strategy is one of several options in the practice of portfolio management. Portfolio management is both art and science; portfolio managers must make critical decisions for themselves or their clients, taking into account specific investment objectives and selecting proper asset allocation, balancing risk and potential reward.

How to build a Defensive Portfolio

  1. The overarching theme to building a defensive portfolio is to focus on high quality companies with strong cash flows, reasonable valuations, and a solid history of operation.

  2. When the market experiences a downturn, you want to own companies that have the highest chance of withstanding the storm.

  3. Cash and CDs (Certificates of Deposit) are the most defensive instruments, but over the long term, they tend to lose purchasing power.

  4. Blue-chip stocks and government bonds are two of the sturdier asset classes if your goal is to build the strongest defensive portfolio possible.

Investments for a Defensive Investment Strategy


Selecting investments in high-quality short-maturity bonds, such as United States Treasury notes (T-notes) and blue-chip stocks are solid tactics for a defensive investment strategy. Even when picking stocks, a defensive portfolio manager will stick to large, established names with good track records. Today, that portfolio manager is more likely to lean towards exchange traded funds that mimic market indices, as these offer exposure to all the established stocks in one diversified investment.

A portfolio manager practicing a defensive strategy may also hold a moat of cash and cash equivalents, such as U.S. Treasury bills (T-bills) and commercial paper can also help to keep pace with inflation and protect the portfolio in down markets.

Conservative Asset Allocation

After deciding which defensive stocks and industries you think could perform best, perhaps the most important determination to a defensive portfolio is constructing a defensive asset allocation. Three common investment classes that typically make up an asset allocation include stocks, bonds and money market investments. How much you allocate to each class can alter the risk profile of your portfolio.

Stocks have higher returns than bonds, but also higher risk. Bonds have traditionally lower returns than stocks, but have the benefit of less risk. A few examples of asset sub-classes and alternatives are listed below.

  1. Municipal bonds: Debt issued by states, cities or other local government entities are commonly known as munis. These debt instruments help finance municipal activities and projects.

  2. Corporate bonds: Corporate bonds typically have maturities of one year or longer. Corporate debt with maturities under a year is known as commercial paper. Bonds issued by companies with high credit ratings are referred to as investment grade or high grade, rated BBB and higher.

Companies with market capitalization typically over $10 billion.

  1. Mid-cap stocks: Medium-sized companies that generally have a market cap between $2 billion and $10 billion.

  2. Small-cap stocks: Typically lower liquidity, higher risk equities with a market cap below $2 billion.

When you’re determining your target asset allocation, aim to maximize return and minimize risk. 

Types of Portfolios– Defensive investment strategies are designed to deliver protection first and modest growth second. With an offensive or aggressive investment strategy, by contrast, an investor tries to take advantage of a rising market by purchasing securities that are outperforming for a given level of risk and volatility. An offensive strategy may also entail options trading and margin trading. Both offensive and defensive investment strategies require active management, so they may have higher investment fees and tax liabilities than a passively managed portfolio. A balanced investment strategy combines elements of both the defensive and offensive strategies.

Here are some examples of conservative and moderately conservative asset allocations and how they contrast with an aggressive one-

Conclusion


 A defensive investment strategy entails regular portfolio re balancing to maintain one’s intended asset allocation. To help protect your portfolio against significant losses during major market downturns you may want to consider high-quality, short-maturity bonds and blue-chip stocks; diversifying across both sectors and countries; placing stop loss orders; and holding cash and cash equivalents.


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