There is an expression that goes “sometimes the best defense is a good offense”. I submit to you… maybe sometimes the best offense is a good defense – at least, if you are investing in times of market turmoil. In other words, avoiding a down market looks a lot like beating an up market. The difficultly (some would say impossibility) is knowing when to be defensive and how much defense is right. The answer is: it depends on the investor, their risk profile, and their goals. Now to answer the question I posed at the outset – what is a truly “defensive” investment?
Many investors and economists would say that investment grade (i.e. the highest quality in the bond market) bonds are a defensive asset. Well, I would agree that bonds can be defensive and do have some attributes of a defensive asset. However, as many investors (very few (none?) of our clients) experienced in 2022, high quality bonds can certainly lose value and produce terrible performance at a time when you expect them to live up to their reputation as a defensive asset.
So, maybe the answer to “what is really a defensive investment” is the good ol’ fashioned greenback. Cash. This one is a little trickier. Certainly, it’s price volatility would be categorized as defensive. But, simple cash has no return… hard to categorize an asset with no return as an investment. And, while occasionally nominal returns are positive but low, money market funds (a cash equivalent) often offer either a flat or positive yield giving the money market funds “investment” status. However, cash or cash equivalents can be a punishing asset to own during times of inflation if near term interest rates don’t keep up with inflation – which they often do not.
Next on the list: Treasury bonds with inflation protection? Okay, now we are getting somewhere! TIPS as they are often called in the financial press are Treasury bonds whose principal is set to increase with inflation. Therefore, when TIPS mature, they pay back the principal plus any inflation adjustment. In addition, as in the principal inflates, interest payments can increase as the rate is calculated based on the adjusted principal. Regardless of the mechanics, TIPS are certainly a defensive asset – whether the return is worth it may be a debate for another post!
Benjamin Graham (a “father” of value investing) might argue that substantially undervalued market assets are defensive investments. In other words, good companies that are priced lower than they should be (if they are well-run companies with competitive products or services) are defensive in that they often have little downside left, may even pay a decent dividend, and offer (at least, potentially) some upside. The critical note for the substantially undervalued asset as a defensive investment is: what if the market is right and that asset/company is undervalued for a reason? Maybe it will be even more “undervalued” next year – or go bankrupt between now and it’s next annual report!
Gold or other precious metals are often top of mind when an investor is asked about defensive assets. I don’t have much to say on this “asset class” as it is very hard to justify arguing that an asset that has no calculable intrinsic value might be considered “defensive”. Same can be said for cryptocurrencies. I am not saying you can’t make money with cryptocurrencies but, keep in mind, it is only recently (very recently) that an investment advisor could even invest in cryptocurrencies – and we have to do that via a fund (generally speaking). So, these assets without calculable value are tough if we are talking about investment assets. But, they could still be seen as defensive if they provide durable, non-correlating return.
The real answer, in my view, is that being “defensive” is a spectrum of risk/return not a point on that spectrum. Being defensive is more about asset allocation and asset correlation than the intrinsic characteristics of an investment. In short, a defensive investment asset/strategy is any asset that helps you ride out market downturns. Defensive assets can play a vital role in an investment portfolio, acting as a possible safeguard during periods of market volatility. While growth assets aim for high returns, they also come with higher risks. Defensive assets, on the other hand, are designed to:
- Preserve capital: Protect your investment from dramatic losses during economic downturns
- Provide stability: Offer steady, maybe even predictable returns, even when markets are turbulent
- Reduce portfolio risk: Balance out more volatile investments, creating a more resilient overall portfolio
So, what is a truly “defensive” investment? Well, there is no airtight answer but an allocation to assets with low correlation, low price volatility and/or consistent yield is a good start. More to come on this topic but, in the meantime, enjoy your day!
