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The Pros and Cons of a Defensive Investment Strategy

October 29, 2020 · 4 minute read

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The Pros and Cons of a Defensive Investment Strategy

While the stock market can offer many advantages to investors, nothing is guaranteed. In recent years, the US has seen the Great Recession, as well as a number of fluctuations since then—events where investors lost tremendous amounts of money.

When the market or economy is volatile, investors might wonder if their portfolios’ asset allocation makes sense for the conditions. One strategy that is often discussed during times of economic stress is defensive investing.

With investing strategies, it helps to know the upsides and downsides before committing to a certain path. Defensive investing, like other investing strategies, has pros, cons, and timing factors to consider for when it might make the most sense to use this strategy.

What Is a Defensive Investment Strategy?

Defensive investment strategies can help investors minimize losses on their investments. In investing terms, the goal of a defensive investment strategy is to minimize the risk of losing principal, while still generating modest returns.

The strategy is what the name suggests: defensive. Instead of an aggressive or offensive strategy, which targets gains and has the potential for high risk, a defensive strategy focuses on preserving capital (read: money), while still pursuing modest growth.

Generally speaking, an investor managing a portfolio with a defensive strategy would likely try to diversify across industries and regions, invest in blue-chip stocks (proven, established companies), regularly rebalance their portfolio, buy short maturity bonds, and place stop-loss orders.

Pros of Defensive Investing

One of the upsides of defensive investing is preserving capital. Because investors target lower risk investments with this strategy, the preservation of capital is king.

This generally means in the case of a market downturn, investors see less of a loss of capital. In addition, some defensive stocks provide dividend income, which can help in the case of stock prices declining.

Defensive investing can also provide confidence of investors who cannot withstand a large loss of capital or who don’t want to worry with each fluctuation of the market.

For investors relying on their portfolio for cash flow, defensive investing aims to help earn a certain amount by not targeting highly volatile or risky stocks.

Cons of Defensive Investing

On the other hand, stability can come with a downside of fewer gains. In a strong market, a defensive strategy will often yield less of a return than a more aggressive strategy.

Another potential con is that a defensive strategy isn’t guaranteed to protect an investor completely. When investing, there is always risk that an investment will underperform.

A potential way to help eliminate the possibility of losing money would be to put money in a federally insured savings account (but remember there are always risks). The downside to that choice is that savings rates are usually below the rate of inflation.

Lastly, a word of warning—sometimes switching to a defensive strategy mid-market downturn is seen as too little, too late. If capital preservation is a priority, this strategy is better employed sooner, before a downturn, than during or after.

What Are Defensive Investments?

Defensive investments are investments with lower risk. This includes a variety of assets. Typical investments in a defensive portfolio are high-quality, short-maturity bonds, such as US Treasury notes, exchange traded funds (ETFs) that mimic market indices, and large, high-quality established company stocks (i.e., blue-chip stocks) and stocks that pay dividends.

A defensive investment could mean money spread across a number of sectors for portfolio diversification, or, buying basic-needs companies, such as utilities, healthcare, food and beverage companies, and waste removal.

Money market accounts, certificates of deposit, and cash holdings are also possible, and lie on the conservative side of a defensive strategy as they offer lower returns than other investments.

The advantage to those three investments is that they’re cash equivalents, meaning that if an investor needs cash quickly, they’re easily convertible.

Defensive Investing in Action

Beyond portfolio asset mix, defensive investing includes strategies such as using stop-loss orders to minimize losses.

A stop-loss order is when an investor tells a stockbroker to sell a stock when its price falls to a predetermined level. Setting up stop-losses helps an investor shed falling stocks automatically, so that losses are minimized.

Another tool for defensive investing is portfolio rebalancing. A portfolio’s asset mix will change depending on how the assets perform; for example, if the stock market is particularly strong, stocks may become a higher percentage of a portfolio than it was at the outset with automatic reinvesting.

Rebalancing is when an investor or portfolio manager adjusts investments to reflect the agreed upon asset mix. For defensive investing, it would likely be a smaller percentage of stocks and a higher percentage of bonds or other, more conservative investments.

When Is It Smart to Use a Defensive Investment Strategy?

When deciding how to invest, it’s important to know the options at hand, and when it’s best to employ a certain strategy.

For defensive investing, several factors come into play. If an investor is risk-averse, this type of conservative strategy may be recommended, as it typically offers less risk.

There are a number of reasons why an investor might be risk-averse. For example, a retiree on a fixed income could fall into this category, or, someone who has limited funds and not much wiggle room for losing capital.

Another possibility is someone who is nearing retirement, and who wishes to preserve the gains they made with earlier investing. An investor who wants to conserve money, yet still aim to outpace inflation, might also choose this strategy.

Outside of individual preferences and situations, defensive investing could be helpful in times of market downturn and volatility.

In the past decade and a half, the US has experienced a recession and financial professionals stopping just short of calling the country’s current economic condition a depression.

In turbulent environments, a defensive investment strategy can help investors sleep at night by keeping assets in less risky investments.

During times of economic stress, investors might opt for a defensive strategy to help them hang on to capital. While no investment is risk free, shifting a portfolio to more conservative assets can help provide a cushion for volatility.

Getting Started Investing

These days, it’s simple to start investing. With plenty of online options, like SoFi Invest®, new investors can explore their options from the comfort of their home and mobile device.

For those hoping to put a defensive strategy in place, there are portfolio diversification options like stocks, curated ETFs, and Stock Bits (less than a share of a stock) to choose from.

For those looking for a more hands-off approach, SoFi offers automated investing. SoFi members can also access expert financial advice by scheduling time to speak with a financial planner for no extra cost.

With SoFi Invest®, investors can trade stocks and ETFs for free (no transaction fees), and can get started investing with as little as $5.

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