How to Invest Defensively In The Stock Market

Investing in the stock market can be a roller coaster ride. With ups and downs that can be difficult to predict. While the potential for high returns is always tempting, many investors also worry about losing their hard-earned money in a market downturn. That’s where learning how to invest defensively in the stock market helps – a strategy that prioritizes safety and stability over high risk and reward.

In this post, we’ll take a deep dive into defensive investing, what it means, and how to do it effectively. We’ll also explore some of the safest sectors for investing and how they perform in both good and bad markets.

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What Is Defensive Investing?

If you’re like me you’ve had a few moments in your life where you’ve woken up in the middle of the night in a pool of sweat. Worried about everything under the sun, but your investments should not be one of them. Learning how to invest defensively will allow you to sleep soundly regardless of the up and down movement in the market.

Defensive investing is a strategy that seeks to minimize risk by prioritizing investments that are relatively safe and stable. These investments tend to be in sectors that are less affected by market fluctuations, economic downturns, and other external factors.

This type of ‘safe investing’ aims to reduce the risk of incurring losses, as well as the overall volatility of a portfolio. Volatility measures the change in value of an asset over time, which can create an issue if investors need to sell assets when prices have dipped, even temporarily.

While defensive investing doesn’t offer the potential for high returns like aggressive or growth investing, it’s an effective way to protect your portfolio during times of market uncertainty. By prioritizing safety and stability, investors can reduce the likelihood of significant losses and build a portfolio that’s designed to weather the ups and downs of the market.

How To Invest Defensively In the Stock Market

Investing defensively means focusing on safety and stability over high risk and reward. This means prioritizing investments in sectors that are less affected by market fluctuations, economic downturns, and other external factors.

By mixing a range of different and uncorrelated assets, investors can build a defensive portfolio while still potentially maintaining much better returns than having your cash under the mattress or at a bank (which is basically the same thing these days).

Some of the most common defensive investment strategies include investing in stable dividend-paying stocks, bonds, and other fixed-income securities. Also investing in sectors that are less affected by market fluctuations, such as healthcare, consumer staples, utilities, and real estate investment trusts (REITs).

With this said, it’s important to build your portfolio according to your individual appetite for risk. Investing should be seen as a long-term strategy. Therefore sitting through a short-term decline, knowing that your investments will recover and grow significantly more than having the funds in cash is important to remember.

Which Sectors Should Be Added to a Defensive Portfolio?

When it comes to defensive investing, there are several sectors that are considered safer and more stable than others. Let’s take a closer look at some of the safest sectors for investing and why they should be a part of a defensive strategy.

As stated above, Defensive sectors are those that tend to perform relatively well during market downturns. They offer products and services that are necessary regardless of the economic environment.

Some of the most defensive sectors include Healthcare, Consumer Staples, Utilities and possible Real Estate and Dividend producing stocks or ETFs. Want to learn more about these specific defensive investments, check out our blog on What Are Defensive Investments?

Can I Just Invest in a Safe Stock?

Buying shares in just one or a handful of individual companies is a high-risk investment option leaving investors nowhere to hide from potential losses if that company underperforms. 

As a result, to invest defensively in the stock market, it’s important that a portfolio doesn’t become too reliant on one company or sector. You need to maintain some balance.

It’s a common mistake to think that you can buy low-risk equities. All equities are high risk. Some sectors are just less risky and less exposed to the economic cycle. Generally, you want a mixture of a range of equity sectors even as a defensive investor.

What Makes An Investment Defensive?

Defensive investments tend to be less volatile and have lower risk levels compared to more aggressive investments. What makes an investment more or less risky compared with others?

Lower Risk

Ultimately this means that the investment is less susceptible to market conditions. Generally these types of companies have a product that has a steady demand that is fairly consistent.

Less Volatile

When an investment is not volatile, the value does not change very easily, it is more stable in it’s growth. Not a lot of ups and downs, more of a steady, but slower rise.

Low Correlation

This measurement has less to do with the individual investment and more to do with how it moves relative to other investments. When building a defensive strategy, you want to consider how each investment’s volatility changes relative to the others in your portfolio. Ideally you want investments that move differently so that one event doesn’t impact all your investments together. Thereby creating some level of safety when others are volatile.

An investment with a low correlation doesn’t make it a good investment by itself, it just means that it moves differently than the rest of your portfolio.

Correlation and Volatility of Defensive Investments

It’s important to consider correlation and volatility when investing defensively in the stock market. Correlation measures how closely an asset’s price moves relative to another asset’s price. Volatility measures the amount of fluctuation in an asset’s price. Defensive sectors tend to have lower correlation and lower volatility compared to the general market.

Healthcare, consumer staples, utilities, REITs, and dividend stocks typically have lower volatility and lower correlation with the general market. This means that during market downturns, these sectors tend to perform better (or less bad) and experience less severe price declines. However, during market upswings, these sectors may not perform as well as higher-risk, higher-reward investments such as growth stocks.

As stated above, the healthcare sector, for example, has a low correlation with the general market because it is less sensitive to economic cycles. People always need healthcare services, regardless of the state of the economy. Similarly, the consumer staples sector provides essential goods that people need regardless of the state of the economy. These sectors tend to be less cyclical and more resilient in a downturn.

On the other hand, sectors such as technology and consumer discretionary tend to have higher volatility and correlation with the general market. Technology companies are often at the forefront of innovation and can experience large price swings due to changes in technology trends. Consumer discretionary companies are often tied to consumer spending, which is highly influenced by economic cycles. These sectors tend to experience larger price swings and can be more sensitive to economic changes.

Why Consider Correlation?

Looking at how correlated a sector is helps to understand how volatile an investment will be. Below we compare the various sectors to the S&P 500. A score of zero would mean the investment is not correlated to the S&P 500. A score of one means the investment exactly aligns with the volatility of the S&P 500.

So here is a summary of the historical correlation coefficients between some popular defensive ETFs and the S&P 500 index:

Ranked from lowest correlation to the highest.

1. Utilities 0.4
2. Consumer Staples 0.4
3. Health Care 0.5
4. Dividend ETFs 0.6
5. REIT ETFs 0.7

Just a reminder that a low correlation doesn’t in itself mean it’s a good investment, it just means that it is less volatile or moves differently than the overall market. So, again, you have less of a drop in a correction, but also less of a gain in a good market.

Defensive Investments Seem Great, Why Invest In Anything Else?

Yep, defensive investments are great. One could argue that every investor should have defensive investments in their overall portfolio. But, the proportion of defensive to aggressive isn’t always a simple conversation.

There are several factors to consider when deciding whether to invest defensively or aggressively, including your investment goals, risk tolerance, time horizon, and financial situation.

Aggressive vs Defensive Investing, Which Is Right For You?

Here are some factors to consider:

Investment Goals

Your investment goals will play a significant role in determining whether you should invest defensively or aggressively. If you’re looking to preserve capital or generate income, a defensive investment strategy may be more suitable. On the other hand, if you’re looking to grow your wealth quickly, an aggressive strategy may be more appropriate.

Risk Tolerance

Your risk tolerance is another crucial factor to consider. If you’re comfortable with the potential for significant losses, an aggressive strategy may be more appropriate. However, if the thought of losing a significant amount of money keeps you up at night, a more conservative defensive strategy may be more suitable.

Time Horizon

Your time horizon refers to the length of time you plan to hold your investments. If you have a shorter time horizon, a defensive strategy may be more appropriate to minimize the risk of loss. On the other hand, if you have a longer time horizon, you may be able to afford more risk and potentially benefit from an aggressive strategy.

Financial Situation

Your financial situation, including your income, assets, and liabilities, will also play a role in determining whether you should invest defensively or aggressively. If you have significant debts or limited resources, a defensive strategy may be more suitable to avoid potential losses. Conversely, if you have a stable financial situation, you may be able to afford more risk and benefit from an aggressive strategy.

Ultimately, the decision to invest defensively or aggressively will depend on your personal circumstances and goals.

Taxes Should Be a Consideration

Another consideration is related to the tax consequences of each investment. I want the most aggressive investments sitting in tax free (ROTH) accounts or slightly less advantaged tax deferred accounts (IRA, 401k).

If you are still working or are in a high tax bracket, then you want the least aggressive investment using taxable money, to generate the least amount of tax consequences. 

Depending on their timeline in their taxable accounts, we will discuss investing this taxable money in real estate private equity for our high-wage W2 earners if they can handle the non-liquid nature of these investments. If they need money liquid, then more defensively oriented investments are king.

The goal here is to end up paying less taxes overall. The investments with the most potential for growth will not be taxed, or taxed when they are in a lower tax bracket (i.e., retirement).

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

In summary, investing defensively is a great way to minimize risk exposure and protect your portfolio during market downturns. However, it is not a one-size-fits-all strategy. What works for one person may not work for another.

Whether you choose to invest defensively or aggressively, it’s essential to have a solid understanding of your investment goals, risk tolerance, time horizon, and financial situation before making any investment decisions.

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.

Want to dig deeper into Defensive Investing? See how Defensive Investing has performed over time and whether it has been a better investment relative to the general stock market. Does Defensive Investing Work to Keep You Safe?

Share your thoughts below. How Do You Invest Defensively in the Stock Market? Have you found it has helped you?