Harris KhanA 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.
What is Defensive Investment Strategy?
The defensive investment strategy is a set of tactics designed to provide a relatively safe return in all market conditions. These tactics include regular portfolio rebalancing to maintain one’s intended asset allocation, the use of stop loss orders and holding cash and cash equivalents in down markets. This strategy is used commonly by investors with conservative goals.
Historical Volatility and Performance
To understand the defensive investment strategy and its advantages, it’s important to look at what has happened in the past. By plotting the historical volatility of various asset classes, we are able to compare the magnitude of gains and losses for stocks, bonds and cash.
By looking at this simple graph, we can see that stocks provide the greatest upside potential, and the downside risk is the smallest. Bonds and cash provide the smallest upside potential, and the greatest downside risk.
In periods of extreme market moves, consideration must be given to these graphs. An investor with a very conservative investment approach may have a portfolio containing 100% cash and cash equivalents, while a momentum investor may have a portfolio with about 50% stocks and 50% cash. Whatever your desired allocation, it pays to be aware of the historical volatility of the allocation you choose.
When Is This Strategy Appropriate?
In general, this strategy is most appropriate for investors with a long time horizon (i.e. ten years or longer) and who don’t care too much about the ups and downs of the market. This is the type of investor for which the “buy and hold” approach is optimal. Such an investor would have made a lot of money by doing nothing but owning stocks through the most recent bull market (1994 to present), which is a very volatile period in history. Of course, the flip side of this is that such an investor would have seen his stock portfolio drop 31% between 2000 and 2002. In such an environment, investors with this sort of approach were rewarded for their patience.
When is this Strategy Irrelevant?
The defensive investment strategy is mostly irrelevant for investors with short time horizons and who wish to be more actively engaged, such as traders and investors with large cash requirements at certain times throughout the year.
This strategy is the most relevant for investors with low risk tolerance, those who have experienced a large loss in the past, and those who have investment requirements that require them to be fully invested at all times to meet their capital requirements.
Does the Strategy Work?
The defensive investment strategy has served investors well over the past several years. There are no guarantees, however, that this will continue to be the case in the future. Whether the strategy will work for any investor depends on your individual time horizon, your investment goals, your risk tolerance and your confidence in your ability to rebalance your portfolio continuously.
Defensive investing sounds like an intelligent strategy if you have the time horizon and personality for it. If you are an aggressive investor and you have the emotional makeup for it. If you are a more conservative investor and you don’t have the emotional makeup for it.
Psychology
A key point made in the article is that if you have an aggressive personality you should have an aggressive approach to investing.
The same thing applies in reverse. If you are a more conservative investor you shouldn’t have an aggressive investment approach. I would suggest that you should have a more passive approach to investment. And by passive I mean you invest in a manner that allows for you to remain calm.
Yogi Berra said “you should be able to see the have in the have not’s.”
This is conservative investing. By being conservative about your investment approach you enable yourself to be conservative about your life. Life is much more fun if you don’t work yourself into a frenzy.
We have created a culture which tells you that you need to work yourself into a manic frenzy to have success. That you need to become a slave to the system and when you do finally collect your winnings you are left a hollow husk. This is not the sort of thing I want in my life.
I prefer to have a more relaxed existence and then use my free time to do more productive things.
Asset Allocation
Another key point made in the article is that if you are an aggressive investor you shouldn’t be putting a lot of money in one asset class.
If you think about it from an emotional perspective this makes sense. If you are all in on stocks what happens if stocks drop 25%? You need to have a portion of of your portfolio that you can turn to that doesn’t involve all of your money.
The article mentions that they recommend that you put 4 times as much into bonds as into stocks. In my view this is overly aggressive. I don’t have a problem with you being aggressive, but if you are going to be aggressive I would recommend applying that same aggression to your asset allocation as well. If you are aggressive about your life why would you be conservative about making your money work for you.
The bane of the face of our existence is having too much of our portfolio in stocks. Yet many people are in denial about risk. In a poll from a few years ago the average investors allocation to stocks was 80%.
This is too much risk. If your time frame is short and you might run out of money (like I might need to do in 5-6 years) you shouldn’t even be invested in stocks at all. If you have a longer time frame and you can take more risk, I would suggest diversifying across more asset classes. To continue with the 80% in stocks example I would suggest having 80% in stocks and 20% in bonds.
This is an aggressive allocation, but alone it is not aggressive enough. I would add 20% in short term TIPS or an ETF that tracks the short term index. Having 20% in cash is a cushion for more conservative investors. Having 20% in alternative investments isn’t going to steal from your returns, in fact it can help your returns.
You need to be aggressive about investing, that is part of how you optimize your life. The better you do at investing the more money you make. The more money you make the more freedom you can create for yourself. The more freedom you create for yourself the better your life will be.
Not Everyone is a Fighter
Not everyone is a fighter. You shouldn’t be a fighter, you should be a lover. Being a lover will open you to more success over the long run.
You should be flexible. You should have an investment approach that works in different environments.
Your investment approach should allow you to keep your emotions steady in different environments as well.
If you are a conservative investor you can defend against the bear. Being defensive doesn’t mean you are weak, being defensive means you are smart. Defensive investing doesn’t mean you are a coward, it means that you are self aware and able to leverage your strengths.
It is a more aggressive fighting style to attack an opponent head on and try to outperform them. That doesn’t always work either. The more intelligent approach is to attack the flank and overwhelm them from a weak point.
Don’t Get Enamored
The more invested you are and the more emotional energy you put into your investments the more you risk making a costly mistake. The more emotional energy you put into your investments the more important they become to you. The more important they become to you the more you are playing with fire.
The goal of your investing should be to put your emotional energy in other aspects of your life.
I will be thrilled if 10 years go by and my investments performed at the rinky-dink Vanguard Admiral Aggressive Growth 70/30 Portfolio.
But I will be more thrilled if 10 years go by and I have created a life that I am enthusiastic about.
If you want to develop a new habit you have to change something else in your life.
If you want to increase your willingness to make social interactions a daily practice, you can do this by creating a morning practice. If you want to become more disciplined in your spending you can do this by paying yourself first. If you want to improve your health you can do this by working out a little longer (say 10 minutes longer), or getting on your bike and riding.
You absolutely can be an aggressive investor while in harness with other aspects of your life. By aggressively investing you can then aggressively pursue your dreams.
If your investment approach requires all of your emotional energy you will be left with a hollow husk.
This isn’t the life I want. Doing something that only satisfies part of my being. Investing aggressively is only going to partially satisfy my being. It is only worth it if you make your investing something that you love. Investing can be an art form and investing can be a craft. You can be both a master of something and an apprentice at the same time.
Conclusion
If you are an aggressive investor you should invest if a manner that is aggressive enough.
If you are an aggressive human being you should invest in a manner that is aggressive enough.
If you invest aggressively but don’t make that extra effort to become a charismatic individual, in all likelihood you aren’t living life to its fullest.
It is better to invest aggressively to secure your future, and then invest in becoming great at something that will allow you to contribute to other people.
