Today, crisis-proof assets are more relevant for investors than ever before. As the Covid-19 pandemic subsided, inflation in Europe and the US surged, prompting central banks to raise interest rates. The negative economic phenomena have yet to be overcome, and there are increasing talks of a potential recession. In such uncertain times, stability in the markets cannot be expected. How to safeguard your portfolio in turbulent times?
What Are Defensive Assets?
Defensive assets, or safe-haven assets, are financial instruments that can generate income (or at least avoid significant losses) during periods of economic uncertainty and market turmoil. This can be understood as follows:
- The value of these assets decreases minimally, remains stable, or even increases during a crisis.
- Interest income remains stable or, in the best case, increases when markets face difficulties.
In essence, you should include at least a few defensive assets in your investment portfolio. They will help reduce drawdowns in its value, thus significantly lowering your risks. However, it’s important to remember that reducing risks comes at the cost of lower returns.
Given this, new investors often ask at least two important questions:
- Is it possible to do without defensive assets in the portfolio?
- Is it possible to create a portfolio consisting only of defensive assets?
A Portfolio Without Defensive Assets
When starting to invest, you must understand that no one forces you to include specific instruments in your portfolio. You are entirely free in your choice: you can compose it only of growth stocks, which might bring you hundreds of percent in annual returns. Alternatively, you can use only dividend stocks, relying on the enormous profits of issuers and tens of percent in payouts.
Is it necessary to include defensive assets in the portfolio? Of course not. However, you must remember one thing: crises often come unexpectedly, especially for retail investors. This was the case during the dot-com crash in the early 2000s, the bursting of the mortgage bubble in 2007, and the outbreak of Covid-19 in 2020.
Why did retail market participants suffer the most significant losses? It’s very simple: most of them are not satisfied with earning $8,000-10,000 a year with an initial capital of $50,000. They need to at least double their investments annually. Is this possible? Certainly, until a crisis hits.
When the market falls by, say, 50% within a few days (as it did in 2007), portfolio resilience becomes crucial. This resilience is precisely what those aiming for quick and substantial gains often lack. Are you prepared for such drawdowns? The decision is yours to make.
A Portfolio of Defensive Assets
A portfolio consisting solely of defensive assets is the other extreme. Yes, it performs excellently during the deepest crises: its value hardly drops, and its income remains stable. However, this income level is low and often doesn’t even cover inflation. Is such a set of instruments what you need?
Nevertheless, analysts assert that it also has its place. This strategy is adopted by those who wish to preserve their capital and are not particularly focused on earning high returns. So, if that’s your goal, don’t hesitate; defensive assets are waiting.
In all seriousness, every portfolio should include defensive assets. The proportion of capital allocated to them is up to the investor. Likely, the investor knows at least the basics of portfolio theory, understands what asset diversification is, and has an idea of which instruments can be considered defensive.
What Are Defensive Assets?
The concept of defensive assets encompasses more than just the trading/investment instruments that can be used to reduce risks and drawdowns during crises. According to Markowitz’s portfolio theory, to manage market turbulence, the portfolio structure should be formed so that the income-generating and defensive parts have the smallest possible correlation coefficient.
Therefore, it is correct to consider those assets defensive, whose correlation coefficient with the stock market is close to zero or even negative. This way, you will have almost perfect crisis management: when the income-generating part of the portfolio declines, the defensive part will not lose value or may even increase.
Defensive assets should possess several general characteristics:
- Liquidity. Assets should be easily convertible into cash at any time.
- Stability. The characteristics of the assets should not deteriorate over time.
- Irreplaceability. Assets are unlikely to become obsolete or be replaced by something else over time.
- Limited supply. The growth in supply should never exceed demand.
It is quite possible that some defensive assets may be replaced by others, so it is important to keep an eye on market trends before investing. Nonetheless, there is a list of defensive assets that have remained so for many years and are favored by investors.
We assume that you now have a basic understanding of defensive assets. It’s time to move on to specific instruments that you can use in this capacity.
Gold
When people hear the term “defensive asset,” the first thing that comes to mind for most is gold. For centuries, humanity has valued gold highly, using it as a store of value. Many of the world’s largest central banks hold significant gold reserves to mitigate risks and hedge against inflation. Historically, gold has consistently maintained or even increased its value during times of uncertainty, stock market crashes, and financial crises.
When uncertainty rises or global markets fall, the first instinct of many investors is to buy gold, as it is often seen as the primary defensive asset. This leads to an increase in demand for gold, and since global gold supplies are limited, its price rises. For instance, with the onset of the Covid-19 pandemic, despite an initial price drop, gold prices soared in the following months. From March to August 2020, gold prices increased by more than 40%, setting historical highs. Today, we are witnessing another round of gold price increases, with new historical peaks.
However, it is important to understand that gold does not necessarily protect against inflation. Its deflationary nature, due to limited supply, is somewhat exaggerated, and its value does not increase in sync with the Consumer Price Index (CPI).
Gold’s correlation with stock market equities is not negative but close to zero. This means that adding gold to your portfolio can only reduce drawdowns and lower risks but not completely hedge against them.
Bonds
Another classic defensive instrument, bonds are favored by both institutional and private investors. Unlike gold, government bonds and stocks have a negative correlation. Bonds usually increase in value when stocks fall, and vice versa, making them a good hedge against crises. Additionally, the price volatility of these securities is low, significantly reducing market participants’ risks.
This happens because, during periods of uncertainty or stock market problems, investors move their funds into cash or reliable bonds. As demand for bonds increases, so do their prices.
Not all bonds are considered reliable. The best defensive instruments are typically government-issued bonds (such as U.S. Treasuries) or bonds from large corporations with significant capitalization and high credit ratings, or in some countries, those with significant government participation.
Keep in mind that bond prices are heavily influenced by their maturity and central bank interest rates. When rates rise, existing bond issues decrease in value, and when rates fall, they increase in value, significantly affecting the yield of these securities. Yield is generally low, so including them in the income-generating part of the portfolio is not particularly sensible.
Inflation-indexed bonds are particularly interesting as defensive instruments. In the U.S., these are TIPS (Treasury Inflation-Protected Securities). The principal of these bonds (and in some cases the coupons) is indexed to inflation. Such bonds maintain their real value regardless of consumer price increases.
Stocks
Perhaps stocks are the defensive asset least used by retail investors. However, some sectors generally perform well regardless of overall market conditions. Stocks of companies in these sectors are considered defensive.
Primarily, look for stocks in companies that produce inelastic demand goods, meaning goods that people will buy no matter what. Examples include companies producing essential goods like Procter & Gamble, utility companies like NextEra Energy, and supermarkets like Tesco. These companies are characterized by high-quality production and sale of goods that generally maintain demand during economic downturns, allowing them to continue operations without significant changes. Some of these stocks also pay dividends to investors!
Dividend yield is another effective method of protecting a portfolio during crises. For example, the S&P 500 “dividend aristocrats” index includes companies that have paid dividends to shareholders for at least 25 years without interruption, with steadily growing dividends. While their prices may fall along with the broader market, dividends help reduce overall portfolio risks.
Reliable foreign currencies can also be considered defensive assets. For instance, American investors often prefer the Japanese yen in their risk mitigation strategies. Another interesting option is commodity assets, whose prices are weakly correlated with other markets. Oil, for example, has a negative correlation with the U.S. dollar.
Overall, choosing defensive assets for your portfolio is not difficult. Just remember that deep diversification significantly reduces risks. However, you must accept lower returns for financial stability. You need to learn to select assets that reduce risks to acceptable levels, ensuring the desired profit.
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