Market volatility can be unsettling and can trigger anxieties about portfolio performance. Understanding defensive investment strategies is crucial. These strategies help protect your investments and offer a buffer against market fluctuations. This article explores how to navigate volatile markets. We will cover key defensive approaches. We should note that this article complemented the article we published May 28, 2024 on capital preservation strategies employed by Hemipheres Investment Management [1].
Understanding Market Volatility
Market volatility is characterized by rapid and unpredictable price swings: several factors contribute to volatility. Economic uncertainty is a primary driver. Geopolitical events, such as military conflict or trade wars can also trigger volatility. Investor sentiment plays a significant role as fear and panic can exacerbate market swings. Understanding these drivers is essential. It allows you to prepare your portfolio to preserve capital. Often however, the most successful strategies include a long-term investment horizon.
Core Principles of Defensive Investing
Defensive investing prioritizes capital preservation. It aims to minimize losses during downturns. Diversification is a cornerstone of this approach. Spreading investments across asset classes reduces risk. Asset allocation is critical[2]. It involves strategically distributing your investments. This aligns with your risk tolerance and financial goals. Risk management is crucial. It involves identifying and mitigating potential risks.
Defensive Asset Classes
Certain asset classes tend to perform well during periods of market stress.
Cash and Cash Equivalents
Cash offers stability during volatile times, it acts as a safe haven. Liquidity allows you to seize opportunities that may arise during a market downturn. However, inflation can erode cash’s value.
Gold and Other Precious Metals
Gold is often seen as a safe haven asset. It can act as a hedge against inflation as precious metals can provide portfolio diversification. However, their prices can be volatile. For more information on investing in this sector, please refer to our blog article “Investing in Commodities,” dated July 29, 2024[3]
High-Quality Bonds
Bonds are generally less volatile than stocks. High-quality bonds offer relative safety. They can provide a steady income stream. Bond prices can still fluctuate as interest rate changes impact bond values. As interest rates decline, higher coupon bonds appreciate. The opposite is true as well, as interest rates rise, bond prices depreciate. For more information on bonds, see our blog article dated, September 12, 2024[4] and July 8, 2024. [5]
Dividend-Paying Stocks
Dividend-paying stocks can offer stability. Dividends provide a regular income stream. Established companies often pay dividends. These companies tend to be more resilient. However, dividend payments are not guaranteed, and the sustainability of the dividend affects stock performance. The following sectors are examples of sectors that frequently pay dividends:
1. Utilities:
- Why: Companies in this sector provide essential services like electricity, gas, and water. Demand for these services is consistent, regardless of economic conditions, leading to stable revenue streams.
- Examples: Companies like NextEra Energy (NEE), Duke Energy (DUK), and Consolidated Edison (ED).
2. Real Estate Investment Trusts (REITs):
- Why: REITs own and operate income-producing real estate, such as office buildings, shopping malls, and apartments. They are required by law to distribute a significant portion of their funds from operations as dividends to shareholders.
- Examples: Companies like Realty Income (O), Simon Property Group (SPG), and AvalonBay Communities (AVB).
3. Consumer Staples:
- Why: These companies produce goods that people need consistently, such as food, beverages, household products, and personal care items. Demand for these items remains relatively steady even during economic downturns.
- Examples: Companies like Procter & Gamble (PG), Coca-Cola (KO), and PepsiCo (PEP).
4. Telecommunications:
- Why: Telecom companies provide essential communication services, such as phone and internet services. These services have become increasingly crucial in modern life, leading to stable demand and revenue.
- Examples: Companies like AT&T (T) and Verizon Communications (VZ).
5. Energy (Midstream):
- Why: Companies involved in the transportation and storage of oil and gas, known as midstream companies, often have stable, fee-based revenue streams. These companies can include pipeline operators and storage facilities.
- Examples: Companies like Enterprise Products Partners (EPD) and Kinder Morgan (KMI).
Important Considerations:
- Dividend Yield vs. Sustainability: While a high dividend yield can be attractive, it’s crucial to assess the sustainability of the dividend. Look for companies with a history of consistent dividend payments and a healthy payout ratio (the percentage of earnings paid out as dividends).
- Company Fundamentals: Always research the company’s financial health, including its earnings, debt levels, and growth prospects. A high dividend yield may be a red flag if the company’s fundamentals are weak.
- Industry Trends: Consider the long-term trends affecting the industry. Some industries may face challenges that could impact their ability to maintain high dividend payouts in the future.
- Diversification: Don’t put all your eggs in one basket. Diversify your dividend portfolio across sectors, industries and regions of the world to reduce risk.
Defensive Investment Strategies
Several strategies can help protect your portfolio.
Strategic Asset Allocation
Adjust your asset allocation based on market conditions. Balance your asset allocation based upon anticipated market conditions, risk tolerance and time horizon. This is especially true during periods of high volatility. Rebalance your portfolio regularly as this helps maintain your target allocation.
Value Investing
Value investing is a strategy that focuses on buying stocks that appear to be trading below their intrinsic value. This means that the investor believes the company is worth more than its current stock price suggests. Value investors look for companies with strong fundamentals, such as solid earnings, low debt, and strong management. They may also look for companies that are temporarily out of favor with the market, or those that are undervalued due to some external factor.
Common Tools in Value Investing
Value investors use a variety of tools to identify undervalued companies. Some of the most common include:
Fundamental analysis: This involves analyzing a company’s financial statements, such as the balance sheet, income statement, and cash flow statement, to assess its financial health and potential for future growth
- Valuation ratios: These ratios, such as the price-to-earnings ratio (P/E), price-to-book ratio (P/B), and dividend yield, help investors compare the valuations of different companies.
- Discounted cash flow (DCF) analysis: This method estimates the intrinsic value of a company by projecting its future cash flows and discounting them back to their present value.
Success of Value Investing
Value investing has a long history of success, outperforming growth investing over the long term. According to a study by Fama and French, value stocks have outperformed growth stocks by an average of 4.4% per year since 1927. See also Hemisphere’s February 3, 2023 article “The Benefit of Value Investing”[6]
Value Investing in a Volatile Market
Value investing can be a particularly effective strategy in a volatile market. This is because undervalued companies are often less likely to be affected by market fluctuations. Additionally, value investors may be able to find bargains during market downturns, as other investors may be selling off their holdings in a panic.
Important points to consider:
- Value investing is not a get-rich-quick scheme. It requires patience and discipline.
- Value investors should be prepared to hold their investments for the medium and long term.
- Value investing is not without risk. There is no guarantee that an undervalued company will appreciate in value.
Overall, value investing can be a successful strategy for long-term investors. However, it is important to do your research and understand the risks involved before investing.
Risk Management Techniques
Effective risk management is essential.
Diversification
Diversifying a portfolio is the most fundamental risk management strategy. It involves spreading investments across different asset classes, sectors, and geographies to reduce the impact of any single investment’s poor performance. One can diversify across asset classes by investing in a mix of stocks, bonds, real estate, and commodity-sensitive companies.
Within stocks, further diversification can be achieved by allocating funds to different sectors like technology, healthcare, or energy, as well as varying market capitalizations (small-cap, mid-cap, and large-cap). Geographic diversification involves investing in both domestic and international markets. Additionally, one can diversify within each asset class, such as holding a variety of bonds with different maturities and credit ratings. Whether you invest in bonds or stocks, you further diversify your portfolio by having limits on position size within the portfolio.The goal of diversification is not to maximize returns, but rather to create a portfolio that can weather market fluctuations and provide more consistent, long-term growth.
Portfolio Rebalancing
Rebalancing your portfolio on a regular basis is crucial, annually at a minimum and preferably quarterly. Investors ensure that asset allocation is appropriate given their investment strategy through frequent rebalancing.
Common Mistakes to Avoid
Avoid emotional decision-making: do not panic sell during market downturns. Market downturns often represent an opportunity to buy excellent stocks at a discount. Do not chase returns in rising markets. Stay disciplined with your investment strategy. Make sure that your asset allocation strategy is appropriate given your risk tolerance and investment time horizon.
Conclusion
Defensive investment strategies are vital in volatile markets. They provide a buffer against market fluctuations. They help protect your capital. Understanding these strategies is empowering. It allows you to make informed decisions. Consult with a financial advisor as they can help you develop a personalized strategy. This strategy should be suitable for your specific needs, it should also align with your risk tolerance. By taking a proactive approach, you can navigate market volatility. You can also work towards achieving your long-term financial goals.
Hemispheres Investment Management
Hemispheres Investment Management is a wealth manager with a global (domestic and international investments in the same portfolio) investment management focus. Our team of seasoned professionals each have over 35-years of experience researching, managing or strategizing investments and investment portfolios, including deep proficiency in U.S., international and emerging markets. Hemispheres can assist you in diversifying your portfolio globally. Global Equities is Hemispheres’ flagship investment product.
Please contact Hemispheres Investment Management for free consultation. We provide guidance and strategies to assist you in optimizing your investment policy and helping you achieve your investment goals. Book a meeting.
This article is for informational purposes only. Consult your financial advisor regarding the suitability of any individual security or sector before investing.
[1] Strategies for Capital Preservation: Balancing Growth and Stability
[2] Understanding Asset Allocation
[4] Core Plus Bonds: A Closer Look at Fixed-Income Investing
[5] An Introduction to Fixed Income Securities
[6] The Benefit of Value Investing
