Why You Should Be Careful When You’re Told To Have A Defensive Portfolio

June 5, 2017

Why You Should Be Careful When You’re Told To Have A Defensive Portfolio

  • Defensive investments are usually promoted to those in retirement or close to it. However, we should all always be defensive investors.
  • Neither bonds nor general stocks are defensive investments, no matter the diversification or quality of the bonds.
  • Cash is the only defensive investment in this market. Other options are positive asymmetric risk reward investments.

Introduction

Many will say that a portfolio owned by an investor who is about to retire or is retired should be a defensive one. However, I find focusing on age isn’t smart because no matter our age, we have to always protect our portfolio and try to maximize returns. After all, isn’t the first rule of investing to never lose money while the second rule of investing tells us to read rule number one again?

The mutual fund marketing machine constantly promotes the “buy and hold for the long term” investment approach and describes market timing activities as a loser’s game by constantly telling us that markets cannot be timed.

In light of the above, I’m first going to describe what should be understood under the word ‘defensive.’ Secondly, I’ll analyze whether we should all have a defensive portfolio now, and if so, how to build one.

Who Is A Defensive Investor?

A defensive investor is one who is first and foremost interested in safety. In Benjamin Graham’s book, The Intelligent Investor, a defensive investor is also described as a passive investor who wants freedom from bother. However, as you’re reading this, you are clearly ready to put some effort in and take the responsibility to protect and increase your wealth.

So if a defensive investor is one who wants safety, thus doesn’t like losing money, I’ll deduce that we should all be defensive investors.

Apart from the irony, the fact is that we should all indeed be defensive investors. If you can separate your investment thinking from the paradigm that only high risk leads to high returns and vice versa, you appreciate a defensive approach even more. I’ll dig deeper into this the risk return paradigm tomorrow, so watch for that.

How To Be Defensive In The Current Environment

If you’ll retire in 10 years or you have just started to invest, not losing money helps in both circumstances.

The standard opinion is that a defensive investor should limit their volatility by owning more bonds than stocks. Well, unlike many might think, this makes a portfolio extremely risky.

Given the low interest rates, bonds are at historically high levels while even high yield bonds have historically low yields, so bonds aren’t going to save you from disaster if we see inflation or higher interest rates. Usually the thing with bonds was that an increase in interest rates compensated for the loss in value. This worked when bond yields increased from 9% to 11%, but it doesn’t really work when yields go from 2% to 4% as it would take more than 20 years for the 2% yield increment to cover for the loss in principal.


Figure 1: The 10-year Treasury yield is still extremely low. Source: FRED.

The situation is similar for stocks. However mutual funds are right, if you own the S&P 500 and your investment horizon is 30 years, the possibility for capital losses is really minimal as there will be dividends coming every year and corporate earnings will likely grow. Therefore, the S&P 500 will be much higher than the current 2,400 points in 30 years. This notion is fundamental to the mutual fund industry as it’s a relative truth and protects the industry from attacks in case of bear markets following irrationally overvalued markets.

However, I would like to add the concepts of expected returns and opportunity costs to the above paradigm as I don’t think many will be happy with what the current S&P 500 offers for the long term and even less happy with the short-term outlook.

Currently, the S&P 500 has an earnings yield of 3.92%. If I attach an expected earnings growth rate of 2% per year, given that the U.S. economy is expected to grow around 2% in the long term, the earnings yield in 30 years will be 7.1%. This means that a person who invests now in the S&P 500 can expect an average nominal return of 5.51% for the next 30 years coming from stocks ((7.1+3.92)/2=5.51%).

This is what I can tell you for the next 30 years. If we shorten the horizon to 20 or even 10 years, the picture changes completely. The FED has clearly said it is going to start tightening. As it usually takes more than a year for changes in monetary policy to affect the economy, we should slowly start feeling the consequences. This means that interest rates will go up, bond yields too, and expected stock returns will also be higher. In case of stagflation, the S&P 500 and most other financial markets would be really toasted.

So if interest rates go up, you can easily expect a 25% or higher decline in bond values, depending on what kind of bond you’re looking at. Consequently as government bonds are riskless, the expected return from stocks should also go up and stock prices should decline.

To summarize the situation, the 10-year treasury yield is 2.21% and it carries the risk of an easy 20% decline if interest rates increase by a few percentage points. The opportunity cost is that you will be soon be able to buy bonds much cheaper and with a higher yield.

As for stocks, their yield is 3.92%. Given there is no maturity on stocks, the discounting is heavier if interest rates increase. So stocks currently yield 3.92% and carry an easy 50% decline risk.

Defensive?

So if both stocks and bonds have a negative risk asymmetry, and the risk is much higher than the reward, where should you invest?

Well if you like stocks and bonds, the answer is obvious, cash. It’s highly unlikely that you will miss on much as long as stocks trade at a valuation of 25.5 and bonds yield 2%, especially as this is the case after an 8-year period of economic expansion. By cash I also mean short term riskless investments like T-bills as long as you keep them until maturity.

Having lots of cash will allow you to buy bonds with higher interest rates, those will come sooner than you might think as the FED is constantly telling us about higher interest rates and a smaller federal balance sheet. The same will apply to stocks as higher interest rates will work like gravity on valuations.

Apart from cash, which is the only real defensive investment in this environment, a small part of the portfolio could be allocated to investments that offer much more upside than the S&P 500’s 4% yield at the same, or even less, risk. I’m talking about investments like emerging market stocks, high growth stocks with stable prospects, miners, and other kinds of alternative investments. Keep reading Investiv Daily to learn more about such investments.