It's good to be defensive

When the stock markets are going up, everybody loves to talk about how well their portfolio has done or the one great stock that made them 50 per cent last year. When the markets go down however, people get very quiet and don’t mention their investments at all.  

For many years, I have coached clients on investing defensively. This approach requires a lot more discipline than the typical investment plan (or lack thereof) and the ability to keep human emotion and greed out of your investment process.  

You see, when the markets are doing well and the average investor goes up 10 per cent, a good defensive portfolio may only gain eight per cent during the same period. Remember, these are the times when everyone likes to talk about their portfolios and brag to their neighbours and friends about how well they’re doing.  

So, it becomes very hard for some people to sit by and “accept” a measly eight per cent return when they keep hearing how others are earning 10 per cent at the same time.  

The greediest people and those with the least discipline will choose to switch at a time like this. They opt to move their more conservative investments over to whatever Joe next door is holding in the hopes of earning 10 per cent again next year. This is the worst mistake you can make though as you’ve not only missed out on the bigger returns from last year but are now in a position to take big losses as well if the markets move down.  

As we begin 2020, I fear that we might be in exactly that type of situation again. The markets all performed very well in 2019 and I’ve heard many recent comments about people moving their investments into higher risk holdings at a time when they should be doing the exact opposite. 

A good defensive portfolio will really shine during the bad years. Let’s say the next year is rough in the markets and the average investor loses 10 per cent during that time. A good defensive strategy might put you in a position to lose two per cent or less during the same downturn or even stay green for the year. You’ll be a lot farther ahead than the masses but you may never know it, as Joe likely won’t be talking about this year’s returns.  

A high percentage of singles and doubles will provide a much better long-term result over swinging for the fences and trying to hit the odd home run. But don’t just take my word on it, let’s look at the math during the 2008 financial crisis:

Defensive Portfolio A lost 10 per cent during 2008. In 2009, the same account grew 10 per cent. So $100 would have dropped to $90 in value at the end of 2008 and then grown back up to $99 by the end of 2009 for a net two-year return of negative one per cent.  

Home Run Portfolio A was down 40 per cent in 2008 but gained a full 40 per cent in 2009. At the end of 2009, you would have only $84 for a net return of 16 per cent over the two years.  

One of the biggest challenges of investing over the long term is staying invested during the difficult times. If someone invested in the Home Run Portfolio couldn’t handle the 40 per cent drop and decided to move their money out, they’d be even worse off as they wouldn’t be around for the partial recovery.  

Even if they did stick it out, they’re still considerably farther behind the defensive portfolio anyways as you need to earn a much larger return just to get back to even.     

Defensive investing is challenging because you’re probably only hitting doubles when your family and friends are hitting home runs. The most difficult part is blocking out the chatter and knowing that you’re well positioned for the long term. 

I’m not saying that the next recession will definitely hit in 2020, but it’s definitely closer than ever. When the next big drop does come, you really can’t go around bragging about preserving capital to all of your friends who just lost their shirts, but you can sleep a little better at night and know that you’re in good shape for the future.

This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.