Why Defensive Investing Wins

From what you hear about investing, you'd think that finding that one big winner is the most important thing you can do to achieve excellent returns. It's because the investment business is built on selling dreams, and people love to dream about that one stock that goes to the moon.

But the real key to making money isn't in the offense -- constantly speculating on high flyers that all too quickly crash back to earth. It's in the defense. If you invest in the stocks that are the least likely to lose money, you'll find that outperformance comes naturally.

Defense wins championships
The first reason why defensive investing works is because it's extremely difficult to make up for a loss. Consider the following stocks:

With an average return of 42% in six months, investors in these stocks must be pretty happy, right?  Well, not if they bought a year ago -- first half-year, the average stock in this group was down by 40%.

Now, one might think that a loss of 40% followed by a gain of 42% should be a small profit.  But if you do the math, you'll find it's actually a loss of 14%, because profits and losses aren't symmetric. For any loss, you need a bigger percentage gain to break even. For instance, if you lose 50% in a stock, you have to make 100% to get back to where you started.

This simple, yet subtle, mathematical property means that it's really hard to make up for a loss. That's one reason why avoiding losses is a critical component to investing success.

Listen to Ben
The second reason defense wins is because the best defensive stocks are also likely to give you excellent returns. Benjamin Graham popularized the concept of buying stocks with a margin of safety: buying stocks for less than what they're worth.

The theory is that an undervalued stock is much less likely to go down than an overvalued stock. With a cheap stock, the bad news will already be priced in, and people prefer to buy undervalued companies, which pushes up the price. Together, these factors make cheap stocks superior defensive investments.

But undervalued stocks also offer an excellent upside, even if they simply return to fair value. Take Intuit (NASDAQ:INTU), which our Motley Fool Inside Value newsletter recommended in early 2005 at a split-adjusted $19. At the time, we estimated that it was trading at about 74% of its fair value. In other words, if Intuit had simply returned to fair value, it would have yielded a nice 35% return.

In the next year and a half, the company grew its earnings, becoming more valuable. What's more, Intuit didn't just return to its fair value -- it exceeded it. The stock marched relentlessly up to $35. At that point, we sold for an 84% gain.

The Foolish bottom line
Now, not all cheap stocks return to their fair value so quickly. But most do eventually. By buying cheaply, you're not just minimizing the downside. You're also getting a bigger upside. And this is why defensive investing outperforms.

If you're searching for these sorts of defensive stocks with great upside, our Inside Value newsletter focuses on exactly these opportunities. You can read our favorite stock picks with a free trial.

Fool contributor Richard Gibbons, being a mean-spirited fellow, thinks its more fun to block than to spike. He does not have a position any of the stocks discussed in this article. The Motley Fool has a disclosure policy.