Does Defensive Investing Work? You Must Read This Now!

Investing can be a daunting task and one of the most important considerations when investing is risk management. While all investments carry some level of risk, defensive investing strategies are designed to help minimize risk and protect investors from market downturns. Of course, when deciding on a defensive strategy, it’s important to consider how effective your portfolio will be when the next stock market correction occurs. And in general, will it even make a difference? Does defensive investing work to keep you safe?

In this post, we’ll take a deep dive into defensive investing strategies, and whether they actually help to keep you safe. We’ll look at specific examples from history and learn how to evaluate your defensive portfolio to gain an understanding as to how safe it is. We also look at defensive sectors and how well they do in good markets as well.

What Is Defensive Investing?

Defensive investing is a strategy that prioritizes preservation of capital over high returns. The goal is to generate consistent returns over time, while minimizing the impact of market volatility. Defensive investors typically invest in stocks or funds that are less volatile than the overall market, such as blue-chip stocks or dividend-paying stocks. They may also allocate a portion of their portfolio to bonds or cash, which are generally less risky than stocks.

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Does Defensive Investing Work To Keep You Safe?

The question many investors have is whether defensive investing really works to keep them safe. Unfortunately as with most investing topics, the answer isn’t a definitive yes or no. While defensive investing can help protect against market downturns, it is not foolproof. Market crashes, economic recessions, and other unforeseen events can still impact even the most defensive portfolios.

However, defensive investing can help investors weather market turbulence better than those who are fully invested in high-risk, high-reward stocks. By allocating a portion of their portfolio to lower-risk assets, defensive investors can help mitigate losses during market downturns.

But first, it helps to understand why certain types of investments handle uncertain times better than others.

Does The Stock Market Only Go Up?

Although looking over time, it is a fairly safe assumption to say that the stock market goes up. I like to say it goes “two steps forward, one step back”. The stock market is subject to market cycles, which can be influenced by a variety of factors, including economic conditions, political events, and investor sentiment.

Stock prices can fluctuate daily, weekly, and monthly based on changes in the market environment. Some years the stock market may experience strong growth, while in other years it may experience decline or even recession.

So, when looking at the performance of the stock market over long periods of time (10 years or more), there are few examples where the market has not been positive.

A few notable exceptions are …

From 1966 to 1982, which is often referred to as the “Lost Decade.” During this time, the S&P 500 index experienced essentially no growth, and investors who held stocks during this period saw no real return on their investment after adjusting for inflation. However, from 1982 to 2000, the S&P 500 experienced significant growth, with annualized returns of approximately 18%.

Also, the period from 2000 to 2010 was challenging, with two significant bear markets and the bursting of the dot-com bubble. However, over the 25-year period from 1996 to 2020, the S&P 500 had an average annualized return of approximately 9.8%, despite the occasional setbacks along the way.

While there have been periods of time when the stock market has experienced significant declines or experienced lower-than-average returns, these periods have generally been shorter in duration. This is why it is important to consider your time frame when considering what types of investments to add to your portfolio. If you have time horizon, you can afford to sit through periods of distress and still take comfort knowing that your investments will recover down the road.

So, what causes these downward movements in the market?

What is a Stock Market Correction?

A stock market correction is simply when the stock market goes down for a period of time. In other words, your investments lose value. Generally speaking, a correction is typically defined as a decline of at least 10% in an index or individual stock price.

The severity of the correction will vary, with some being relatively mild and others resulting in significant declines. But they are always a drop of at least 10%.

How Often Does The Stock Market Correct?

Market Correction

Historically, stock market corrections occur every year or two.

Bear Market

A “Bear Market” is a larger stock market correction. Bear markets are corrections of 20% or more. They, historically, occur once every 3-5 years on average.

It’s important to note that these time estimates are just an average. There have been periods where the market has gone several years without experiencing a correction. As well as periods where multiple corrections or bear markets have occurred in a relatively short period of time.

Why Do Stock Market Corrections Occur?

Stock market corrections occur for a variety of reasons, including changes in market sentiment, economic data releases, geopolitical events, and company-specific news. For simplicity, I want to focus on a common reason why we enter a bear market, which is the more severe correction that we can have.

If you think about how to invest defensively, you must consider what happens in an economic downturn. What do YOU do when you are scared for your job? Or scared you might not have enough money to pay your rent or mortgage?

Generally speaking, you tighten your belt. You buy only essential items and stay away from purchasing more extravagant items like a new car. And, if you amplify this across the entire country with everyone doing the same thing, suddenly large businesses are severely impacted by no one spending money.

Understanding Investor Psychology

So, in the stock market what you’ll see in an economic downturn or the threat of one is a shift in investor appetite away from high-growth companies, particularly those in the technology sector, to businesses in less cyclical sectors. 

The latter includes companies that benefit from all-around demand for their products, including essentials such as food, drink, and healthcare products. Remember, in a downturn, you will give up on the extravagant items, but keep purchasing and possibly even stock up on the items that you consider are essential.

You aren’t going to pass up on the medicine you take monthly that keeps you alive, or cold medicine when you get sick. You also aren’t going to turn off the heat in the house.

But you might skip the latest phone upgrade. Or take your car to the repair shop instead of trading it in for a newer one.

Does Investing Defensively in the Stock Market Work?

Obviously, this is the big question, does investing in defensive sectors actually help you to be safer when investing in the stock market? Technically speaking, yes. Investing in defensive sectors is an effective strategy to minimize the bloodshed in your portfolio during a correction or bear market, but it’s more complicated than that.

First off, lets look at some specific examples comparing defensive sectors to the general market …

The Crash of 2008

The stock market crash of 2008, also known as the Great Recession, was a global financial crisis that began in 2008 and lasted until 2009. During this period, stock markets around the world experienced significant declines, with the US stock market being particularly hard hit.

So how did these various sectors compare with the total declines for the S&P 500 and NASDAQ during the 2008 crash? Total decline means the total drop in value from the peak in October 2007 to its low in March 2009.

Ranked in order from best to worst …

1. Consumer Staples Select Sector ETF (XLP) -30.4%
2. Health Care Select Sector ETF (XLV) -38.2%
3. Utilities Select Sector ETF (XLU) -43.6%
4. iShares Select Dividend ETF (DVY), declined 53.6%
5. NASDAQ index -54.5%
6. S&P 500 index -56.8%
7. REIT, Vanguard Real Estate ETF (VNQ) -71.6%

*The bear market of 2008 had A LOT to do with real estate, which is why it fell so much worse than the other sectors. This is not normal for a bear market, but important to consider.

Covid-19 Crash in 2020

The drop of 2020 (Covid) saw a similar situation (from its peak on February 19, 2020, to its low on March 23, 2020)

Ranked in order from best to worst …

1. Consumer Staples -17.9%
2. NASDAQ -23.1%*
3. Utilities -30.8%
4. Health Care -31.3%
5. S&P 500 -33.9%
6. Dividend ETFs -39.7%
7. REIT ETFs -44.2%

*Covid created a remote workplace boom, which really helped technology stocks, not a normal occurrence during a bear market.

Dot Com Bust of 2000

And, lastly let’s look at the big daddy of bear markets in our recent history, the dot com bubble burst of 2000 which lasted until 2002.

Ranked in order from best to worst …

1. Consumer Staples -25.1%
2. Dividend ETFs -34.3%
3. Utilities -38.5%
4. Health Care -42.4%
5. REIT ETFs -44.3%
6. S&P 500 -49.1%
7. NASDAQ -78.4%*

*The dot com bubble of 2000 was primarily a result of the late 90’s insanity oriented around the beginning of the internet. Technology companies increased their values insanely in this time, so it makes sense that that industry was the hardest hit when the boom ended.

History Doesn’t Repeat, But It Rhymes

I find it very helpful to look at past market events to gauge what can occur in the future. It is not guaranteed, but it does help to set an expectation. And, looking at three examples isn’t enough data to gain a firm understanding, even if these three were the worst bear markets that we have had in the recent past. So, what does the above teach us?

here Are No TRULY Safe Investments in the Stock Market

Generally, what we see is that these sectors can help minimize the loss in a portfolio. But it’s important to note that all of these sectors lost money. There was no safe place in the stock market.

Do Safe Investments Perform Well in Good Markets?

The other important thing to consider is that just because it does ‘less bad’ in the bad markets, how does each perform in good markets. In other words, if you have a 10- or 20-year time horizon, does losing less in a bear market ultimately put you ahead of the more volatile stocks.

And the quick answer is that, if you have a long-time horizon, as hard as it is to stomach, you are better off investing in the more aggressive growth industries that might fall hard in a correction but rebound incredibly when times are good.

In general, what we see is that these ‘defensive’ sectors are less correlated (or less volatile) with the general market, which basically means that they fall less in bad markets, but they also rise less in good markets.

How Do Defensive Investments Perform When the Stock Market is Doing Good?

While defensive investments tend to do “less bad” in down markets, they may not perform as well in good markets. Let’s not forget that the market goes up 75% of the time. So, while it is important to minimize your risk, you don’t want to sit in an investment that severely underperforms in good markets if your time frame is long term.

Looking at the 20-year return (where there were good and bad times) gives us a good gauge of the overall performance.

Ranked from best to worst.

1. NASDAQ: 893%
2. Health Care: 596%
3. S&P 500: 452%
4. Utilities: 363%
5. REIT ETFs: 360%
6. Consumer Staples: 338%
7. Dividend ETFs: 330%

So, even cringing through the corrections that occur every 1-2 years, if you have a long-time horizon, it can pay to take the more aggressive road.

Looking at a 30-year period, the contrast is even more stark …

1. NASDAQ: 4,319%
2. Health Care: 2,117%
3. Consumer Staples: 1,482%
4. Dividend ETFs: 1,372%
5. S&P 500: 1,248%
6. REIT ETFs: 1,255%
7. Utilities: 1,122%

It’s important to consider your investment goals and time horizon when deciding whether to invest defensively or in higher-risk, higher-reward investments. If you have a longer time horizon and can handle short-term volatility, growth stocks may be a better investment choice as they tend to outperform over the long term.

Jesse Livermore once said, “The stock market is never obvious. It is designed to fool most of the people most of the time.” Therefore, a defensive investment strategy can provide a level of protection and stability in a volatile and unpredictable market.

Your Time Frame Matters

Looking at the above, your investment time frame should be an important consideration when deciding whether to invest aggressively or defensively.

If you have a longer investment time frame, such as 10, 20, or even 30 years or more, you may be able to tolerate more risk and invest more aggressively. However, if you have a shorter investment time frame, such as five years or less, you may want to invest more defensively to protect your capital. Since in the short term, the stock market can be volatile and unpredictable, and a sudden downturn could significantly impact your portfolio.

When sitting down with our clients, I suggest we segment their investments into separate risk/time “buckets”. Where we invest aggressively with their longer-term (IRA, 401k) investments and orient the shorter-term into more defensively oriented investments.

What is Your Risk Tolerance – It’s Important

Over the long run, the clear winner BY FAR is high growth, very volatile technology companies in the NASDAQ. In fact, there is not even a close 2^nd place. But you do have to factor in your particular comfort level in the decision as to where to invest.

Are you comfortable earning 4,319% over the next 30 years, but knowing that there will be a multi-year period where the value of your portfolio will drop 78.4% (like it did from 2000 to 2002)? And, by the way, it took 3 years to hit bottom, but took another 10 to get back to break even!! So, an investor sat with a loss in their portfolio for 13 years!

The crash of 2008 has similar results … with a loss of 55% from October 2007 until the bottom in March 2009. It took another 6 years (April 2015) to get back to its pre-crash peak.

Talk about waking up in a pool of sweat!! Do you have the stomach to sit through such a loss knowing that eventually it will be a smart investment??

Investing Defensively In The Stock Market May Be Safer, But Not Always Smarter

In summary, defensive investing is an excellent strategy for investors who want to minimize their risk exposure in the stock market. By investing in defensive sectors such as healthcare, consumer staples, REITs, utilities, and dividend stocks, investors can reduce their risk of loss during market downturns. However, it is essential to understand that defensive sectors generally do not outperform the broader market during bull markets. As a result, a balanced approach including both defensive and growth stocks is ideal for long-term investors.

Share your thoughts below. How comfortable are you sitting through big losses in your portfolio knowing that you will end up in a better place in the end?