How to play investment defense

Focus on optimal asset allocation

Inflation continues to burn up everyone’s purchasing power, with both Canadian and U.S. consumer price indexes exceeding an annual 8% recently. Of course, any shopper could have told you that months ago, just by looking at weekly price hikes on store shelves. And after swearing up and down all through 2020 and 2021 that inflation would be “transitory” and that interest rates would remain low for a long time, central bankers have done a 180-degree turnabout and are raising policy interest rates to levels not seen in decades, with more rate hikes to come until inflation is tamed.

But steeply rising interest rates act like a lead weight on stock markets, and sure enough, the major stock market indexes have dropped like a stone this year, entering a vicious bear market cycle. As the yield curve on government bond issues inverts, and short-term bonds yield 25 basis points more than long-term yields, a recession next year seems increasingly likely.

Naturally, investors want to do what they can to protect their capital and limit their downside to their predeterimined levels – at least for those who have developed a financial plan and investment portfolio strategy with just this contingency in mind.

But other investors, who tend to fly by the seat of their pants, typically ask me to recommend some “defensive” fund investment categories that would see them through the coming, highly unpredictable bear market cycle. My answer is that this is one of those questions that seems straightforward enough, but is in fact quite complex. The short answer is that there are no “defensive” fund categories as such. And even if I could make recommendations on this basis, I wouldn’t. Here’s why.

When I was asked about “defensive” funds, the person was really asking me about more “conservative” versus more “aggressive” fund categories. This all has to do with relative levels of risk (with “volatility” being the key metric in the world of investment funds).

Some fund categories can be construed as perhaps more “conservative” than others, if you use the standard capital asset pricing model as a guide. For instance, money market funds are considered ultra-conservative and virtually risk-free, because they invest in highly liquid short-term government Treasury bills. In other words, their unit values hardly fluctuate at all. The flip side to this is that because reward is commensurate with risk, money market funds pay out virtually nothing, and may even produce a negative yield once you factor in tax and inflation.

Moving up the capital asset curve, you come to fixed-income funds. These are considered more risky than the ultra-conservative money market funds, and typically provide a better return when rates are falling or remain very low. But because bond prices and yields change not only with the prevailing level of interest rates but also with interest rate expectations, bond funds have taken heavy losses as rates have climbed.

Equities are quite high up on the risk-reward curve, and can produce the largest gains and losses, because prices are subject to so many disparate influences. But when a bearish trend sets in as a result of weakening macroeconomic conditions and rising interest rates, there’s nothing so damaging to investors who have the bulk of their assets tied up in the stock market, either directly or through mutual funds and exchange traded funds.

For investors in this situation, there is simply no easy way out. If you didn’t take steps to lighten up or exit your equity allocations at the start of this year, and switch to cash or near-cash assets, it’s likely too late now. You’ll have to ride the bear until it gets fatigued and take your lumps. You might consider switching from aggressive, volatile sectors to more “defensive” sectors, such as utilities, where a steady dividend stream creates a floor of sorts under the share price.

Playing it smart

Instead of reacting to market turmoil as it happens, it is far more prudent to approach your portfolio decisions from an overall asset allocation perspective from the outset. By this, I mean you should decide honestly about your level of risk tolerance. Then construct a diversified portfolio comprising safety, income, and growth categories in various proportions that reflect your risk comfort level.

If you’re more aggressive, for example, you’re likely to weight your portfolio more to categories and funds displaying a higher risk-reward ratios, probably chosen from among growth funds. And you’ll have slightly lower weightings to fixed-income categories, which you’ll still need to mitigate overall portfolio risk, but which you’ll underweight so as not to dampen overall performance. If you’re a more conservative investor, you’ll adjust your asset weightings the other way.

In either case, or even if you’re a 50/50 balanced investor with equal holdings in growth and fixed-income, it makes a lot more sense to develop an asset allocation strategy to suit your comfort level, and then stick with it, making only minor rebalancing adjustments when necessary. Your portfolio will see you through these inevitable market challenges, such as we’re seeing right now, and will be more likely produce better overall returns in the longer term.

And that’s the best “defensive” strategy of all.

Robyn Thompson, CFP, CIM, FCSI, is the founder of Castlemark Wealth Management, a boutique financial advisory firm specializing in wealth management for high net worth individuals and families. Contact her directly by phone at 416-828-7159, or by email at rthompson@castlemarkwealth.com for a confidential planning consultation.

Notes and Disclaimer

The foregoing is for general information purposes only and is the opinion of the writer. Securities mentioned are illustrative only and carry risk of loss. No guarantee of investment performance is made or implied. It is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. Please contact the author to discuss your particular circumstances.