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Defensive: Investing Essentials

Source: via Flickr.

It's been demonstrated over time that the stock market offers investors solid returns if they're willing to stick around over the long term. However, that doesn't mean wild gyrations haven't occurred at numerous points throughout history.

Take the Great Recession of 2007-2009 as a perfect example: The S&P 500 dropped by more than 50% and then more than doubled in the years following the end of the recession. These peaks and troughs represent incredible opportunities for investors -- but for many they were only cause for indigestion. This is why defensive stock investing was created in the first place.

What is defensive investing?

By the simplest definition, defensive investing seeks to minimize your capital-loss potential and portfolio volatility while maximizing your chance to profit in any market conditions. Defensive investing can include some, or all, of the following:

  • Cautiously allocating your money across a number of sectors to stay diversified.
  • Seeking out high-quality, dividend-paying stocks.
  • Seeking out companies deemed to be "value" stocks.
  • Buying blue-chip, brand-name, or basic-needs companies.
  • Buying low-beta companies (beta is a measure of volatility in relation to the S&P 500).
  • Using stop-losses to minimize losses.

The general idea is to seek out investments that appear to have minimal downside potential and/or that provide you with annual income -- i.e., dividends, which can help offset a downtrend in the stock prices.

What is the history of defensive investing?

Defensive investing has arguably been around since companies began paying dividends well over a century ago. However, there are two key factors that appear to have played a key role in improving investors' awareness of the importance of defensive stocks.

First, a number of high-profile investors have been successful because they rode the coattails of companies that can only be described as defensive. There may be no more famous pioneer of defensive investments than Warren Buffett. One of the primary ways Buffett built his fortune was by investing in "boring" companies that provide basic-needs products, such as food, railroads, and even insurance, which is a requirement if you drive or buy a home.

People often try to emulate the strategies used by the stock market's most successful investors, which has put much-needed attention on defensive stocks.

Secondly, the natural course of the U.S. economy is that it peaks and troughs every so often. Every generation of investors has been through a sizable stock market correction that has engrained the idea of diversification and capital preservation in everyone's minds.

How many defensive investing approaches are there?

There are more than a handful of ways to invest defensively -- and the best news is that they can all be successful. What matters most is that investors choose a strategy that suits their risk tolerance.

Source: Simon Cunningham via Flickr.

For example, investors can choose to throw diversification out the window and focus on investing specifically in defensive sectors, such as utilities. Utilities provide basic needs, such as electricity or water, they often have stable pricing power in regulated markets, and they usually return impressive dividends to shareholders.

Another possible defensive strategy involves focusing on dividend-paying companies. Dividend income, and the ability to reinvest that income, offers investors an opportunity to use the power of compounding gains over time to grow their nest egg.

Investors can also combine some of these aforementioned strategies and build a diversified portfolio that's also focused on dividends, blue-chip stocks, low-beta companies, or some combination thereof. And there are more possible strategies investors can take that haven't been listed here.

What is the advantage of defensive investing?

The most obvious advantage of purchasing defensive stocks is that they have the potential to protect investors' capital during a downturn. Defensive stocks usually provide dividend income, which can offset declines in stock prices. Additionally, defensive stocks often have a beta of less than one, implying lower volatility than the benchmark S&P 500. In other words, if the stock market drops, a defensive investor can expect to see a smaller loss, in percentage terms, than the benchmark S&P 500.

Source: via Flickr.

As has been alluded to above, a number of basic-needs products and services are also defensive in nature. This is important because basic-needs companies (e.g., utilities, food and beverage companies, and refuse removers) have inelastic prices for their products and services, which leads to predictable cash flow and profits. Think about it: Consumers have to purchase toothpaste, detergent, baby diapers, food, and many more items and services, regardless of whether the U.S. economy is growing 5% per year or contracting. This means basic-needs companies have little need to discount their products and services. The end result is usually portfolio stability for the investor.

Of course, defensive investing also comes with one downside: Low-volatility stocks tend to underperform during a bull market. When the U.S. economy is rapidly expanding and stocks are moving precipitously higher, less volatile companies usually get left behind as investors' appetites for riskier investments rise.

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Sean Williams

A Fool since 2010, and a graduate from UC San Diego with a B.A. in Economics, Sean specializes in the healthcare sector and in investment planning topics. You'll usually find him writing about Obamacare, marijuana, developing drugs, diagnostics, and medical devices, Social Security, taxes, or any number of other macroeconomic issues.

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