Specializing in retirement planning and personalized investment management.

Play Portfolio Defense

Play Portfolio Defense

Sometimes the best offense is a good defense.  Keeping what you have can be as important as growing what you have.  Assuming your investment portfolio is already well diversified and there is not a lot of unnecessary risk, here are some portfolio strategies to consider if you’re defensive-minded.  Some of these are covered on other pages, but others are new.

Stock Side of Portfolio

Utilities Fund:  Utilities have long been considered a good defensive sector. While we don’t normally do sector bets, a utilities fund can be worked into the portfolio.  Besides defense, it also can increase the yield of the portfolio.

Preferred Stock Fund:  As a hybrid between stocks and bonds, preferred stock funds are usually less volatile than broad market indices like the S&P 500. They can also increase the yield of the portfolio.

Covered Call Fund:  The income from a covered call fund can turn a flat market into a profitable one and help offset losses in a down market.

Use Stop-Loss Orders:  While we mainly use mutual funds to attain certain dynamics within our portfolios, we do use Exchange Traded Funds (ETFs) as well.  An advantage of ETFs is that you can place stop-loss orders on them because they trade throughout the day.  So if you bought an S&P 500 fund at $50/share, you could enter a stop-loss order at $43/share knowing you are limiting your downside, but yet your upside remains intact.  Or if the fund has increased to $60/share, you could use a stop-loss order at $54/share to lock in a profit if the market turns.

We can create an all-ETF portfolio to hedge against, or add them in with our standard recommended mutual funds for a blended approach.  While stop-loss orders can protect against large losses, they can also work against you.  Most people envision a worst case scenario when thinking about stop-loss orders (If I buy a fund at $50 it could drop to $25, I better do a stop-loss).  In reality, stock funds slowly move up and down, and they often reverse course. In the two scenarios above, what would you do if your fund dropped to the stop-loss order price, it executed, and then the fund started to climb? A buy-and-hold investor would still receive those gains, but you’d be sitting in cash.  It is paramount to have a game plan in place for getting back into the position/market when using stop-loss orders.  We won’t implement this strategy without one.

Market Hedging Funds:  Not to be confused with “hedge funds”, market hedging funds are basically funds that perform inversely to a segment of the market like the S&P 500.  If the S&P 500 is down 10%, you can expect a market hedging fund to be up about 10%.  In a down market, a stop-loss order can limit your losses, but a market hedging fund can actually make you money.  These funds are typically more expensive and of course perform terribly in a bull market.  However, a small dose in your portfolio may help ease your mind.

Less Stocks / More Bonds:  A portfolio allocation has to help you reach your short-term and long-term goals, but it also has to be built with your comfort level in mind.  It’s very important to understand and discuss your comfort level ahead of time.  However, we realize that sometimes things change, either because of life events or just a generally uneasiness about the market.  If this applies to you, or if you’re defensive-minded, it may be better to start off with (or move to) a lower stock percentage for your allocation.

Bond Side of Portfolio

Increase Credit Quality:  The two biggest risks to bonds are credit risk (default) and interest rate risk (rate fluctuations).  By selecting bond funds holding higher rated bonds, you can decrease your credit risk.  This might mean decreasing or even eliminating exposure to high yield (lower quality) bonds.  The more you increase the creditworthiness of your bond portfolio though, the lower the expected yield will be.

Lower Duration:  Duration, expressed in years, is a measure of a bond investment’s sensitivity to a 1% change in interest rates. If a bond fund has a duration of 5 years and interest rates go up 1%, you can expect the bond fund to lose about 5% in value.  You can lower your interest rate risk by lowering the duration of the bond funds you have in your portfolio.

Bond Ladder:  Bonds held until maturity have very little interest rate risk.  If you don’t mind holding individual bonds, you could buy bonds that mature say every 6 months for the next 5 years.  This is referred to as a bond ladder.  You collect interest along the way and every 6 months a bond matures and you are paid principal back.  You could either use that money for expenses or invest it at the tail end of the ladder, thus creating a “rolling” bond ladder.  Barring an emergency sale by you or default on the issuer’s part, you would pretty much lock in your interest and principal over the term of the ladder.  This can be used as an income strategy, a defensive play against rising interest rates, or as an extension of your cash reserve (the ladder replenishes the cash reserve over time)

Bond ladders can be highly customizable.  However, the more complex the ladder you desire, the more difficult it will be to build and maintain (a bond ladder maturing every quarter will be more difficult than one maturing once a year).  Also, keep these things in mind:

  • You’re probably only buying a handful of bonds which opens you to concentration risk.
  • The spread on individual bonds can be bigger than what you’re used to with stocks and ETFs.  Institutions buying $1M or more have much smaller spreads than retail investors buying in at $25K or $50K.
  • You’ll need a decent amount of money to buy all the bonds needed.

Target Maturity Bond Funds:  Target maturity bond funds are funds that hold a collection of bonds until maturity.  They are available in various maturities for investment grade, high yield, and inflation-protected bonds.  You could buy certain ones to mix in with your regular bond funds, or you could build a “bond ladder” with them.  You won’t get the customization of a true bond ladder, but you do get simplicity (less hassle building a ladder) and more diversification (many funds hold hundreds of bonds).

Floating Rate Bond Fund:  Another way to combat the threat of increasing interest rates is to invest in adjustable rate bonds.  These types of bonds have rates that often move with the market, so if interest rates go up, so does the bond’s.  They are usually short-term in nature, but may have lower yields vs. comparable fixed rate bonds.  It’s important to know the make-up of a floating rate bond fund as many hold lower credit quality bonds.

Withdrawal Strategies

Increase Cash Buffer/ReserveWhen you begin withdrawing from the portfolio, we normally have a cash reserve of 12-24 months of withdrawals in money market and CDs.  This acts as a buffer between monthly cash needs and the investment portfolio.  We usually start to build out the cash reserve 1-2 years prior to retirement / withdrawing in order to smooth out the transition.  At the expense of some yield, you could accelerate this process prior to retirement or hold more in cash to represent more months of withdrawals.

Dynamic Withdrawal StrategyMost people withdrawal a certain monthly dollar amount from their portfolio for several years and then adjust as necessary (you don’t usually see people take a fixed percentage withdrawal from their portfolio and increase it every year for inflation as often depicted in “4% Withdrawal Rule” research and discussions). If a couple needs $3,000/month from their portfolio, they may take that amount for several years, and then increase it to $3,250 for several more years regardless of how the market performs.

A dynamic withdrawal strategy is simply adjusting the monthly withdrawal amount based on how the portfolio is performing.  You spend less in bad times and more in good times.  If you were taking $3,000/month from your portfolio and it has lost 5-10%, then you would maybe reduce your withdrawals to $2,750/month.  Likewise, if the portfolio was doing well, then you might increase your withdrawals by a few hundred/month.  There are a variety of ways to implement this (benchmark vs. a certain withdrawal rate or portfolio performance, measure once a year or more often, etc.), but we suggest sticking with simple rules.

Most annuities, with their guarantees, are considered defensive.  However, because this section is about being defensive with your long-term investment portfolio, they are discussed elsewhere.