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Don’t play ‘defense’ in the markets

by | Oct 18, 2013 | SELF-PUBLISHED

Don’t play ‘offense’ either – play it smart

Markets can be unpredictable in the fall. Also in the winter, spring, and summer. I got to thinking about this when I was recently asked to recommend some “defensive” mutual fund investment categories that would see an investor through the “unpredictable” fall season with moderate gains. 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…

In the world of sports, defense and offense are pretty straightforward concepts. Not so when it comes to investing. Many investors get tangled up in the numerous sports, gambling, and military metaphors that litter the financial lexicon. But investing is not like sports, gambling, or the battlefield. The ironic part is that if you look at investing and money management in those terms, you will certainly end up on the losing side.

RISKY BUSINESS

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 mutual 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 (Government of Canada 90-day T-bills were recently yielding 0.99%), 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 slightly more risky than the ultra-conservative money market funds, and typically provide a better return. That’s because bond prices and yields change not only with the prevailing level of interest rates but also with interest rate expectations, so there’s a capital gain component in the equation as well. However, bond funds are still considered less volatile than the next riskiest class: equity funds.

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, including the sort of seasonality previously mentioned. However, here, too, we must be careful in making blanket generalizations. The fall period is not always a slow or negative one, and it is exceedingly dangerous to construct an investment thesis on the anticipation that it will follow previous seasonal patterns.

PLAYING IT SMART

It is far more prudent to approach your portfolio decisions from an overall asset allocation perspective. 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 ratio, 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.

THE BEST “DEFENSE”

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 those inevitable short-term soft spots, and will be more likely to produce better overall returns in the longer term.

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

 

© 2021 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

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