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An Arsenal for the Defensive Investor

Here are 10 ways you can shield your portfolio from more market damage—and maybe even fight back a little

Investors' assets are under siege.

Since the start of the year, companies in the broad stock market benchmark S&P 500 index have lost nearly $2 trillion in market value, the blue-chip Dow Jones industrial average has flitted in and out of bear territory, down nearly 20% from its October 2007 high, and the corporate bond default rate has more than doubled. To boot, U.S. home prices have dropped more than 16% over the past year in the country's 10 largest cities, according to the S&P/Case-Shiller Home Price Index for May. It's been a gut-wrenching experience for investors watching retirement savings and future college tuitions get hammered.

Some pros caution against any substantial moves after a market rout has already happened. But investors can still dodge the recessionary blows—or even start fighting back. For those who can't stomach the thought of additional losses, switching to cash or U.S. Treasuries is never a bad option; over the last 10 years, a savings account yielding 2% has returned more than the S&P 500 Index. And for resilient investors with slightly more appetite for risk, putting money in funds that take short positions against major stock indexes, or even buying certain types of corporate debt, can still limit downside while spurring returns.

How can investors play defense? In the grand scheme of things, the No. 1 strategy should be diversification. But you should already be doing that, whether times are good or bad. Digging a little deeper into the defensive playbook, here we present a 10-level approach to defensive investing—an arsenal recommended by financial professionals, ranging from the iron-clad safety of cash to vehicles with slightly more risk but with a reasonable degree of safety, like bank bonds.

1. Cash

So it's not the most exciting choice, but for those too bedeviled by the market's recent unpredictability to dabble in stocks, investing in cash is a good defense. Banks offer money market accounts—essentially limited-withdrawal savings accounts that accrue interest—to attract deposits. They are insured by the FDIC for up to $100,000 and generally yield anywhere from 2% to 4% annually. Though less liquid, a certificate of deposit is a higher-yielding cash option. Considering that $1 invested in the S&P 500 in January 2000 is worth about 87¢ today, cash isn't necessarily a terrible refuge. "People always pooh-pooh cash," says Rich Bernstein, chief investment strategist at Merrill Lynch (MER). "But at least it's up."

2. U.S. Treasuries

Of course, U.S. Treasury bond returns aren't exactly sexy, but they are steady. As of July 29, 10-year Treasury notes yielded 4.04% for investors, while 30-year bonds stood at 4.62%. The problem with this investment is that, while returns are automatic, they won't necessarily beat inflation. For example, a two-year note today yields 2.62% per year. That's well behind the 5% annual overall inflation rate according to the June consumer price index (CPI). So while investors can sleep tight knowing that the "full faith and credit" of Uncle Sam is backing their investment, their purchasing power might be taking a hit. "If you bought a bond today with a 5% yield and inflation averaged 6% over the next 10 years," says Jonathan Bergman, chief investment officer at Palisades Hudson Asset Management in New York, "you'd have a terrible investment."


That's why the Treasury offers bonds that factor in inflation. TIPS, or Treasury Inflation-Protected Securities, are fixed-rate bonds whose principal grows (or shrinks) at the same rate as inflation. Investors can purchase the notes in $100 multiples through the Treasury's official Web site. At the latest TIPS auction, a 20-year bond expiring in July 2028 yielded 2.21%. "TIPS might be a good place to start" for defensive-minded investors worried about rampant inflation, says Hank Hanau, president of New York financial adviser HFH Planning. The notes pay interest twice annually, and the principal is adjusted each time to correspond with changes in the CPI. For example, a $100 note returning 2.5% would become a $105 note returning the same percentage if yearly inflation were 5%.

Yet TIPS aren't perfect either, warns Hanau. TIPS correspond to the CPI, an inflation index that many believe understates the impact of rising fuel or food prices, he says—the very sectors that economists agree are driving inflation today. (Morgan Stanley (MS), for instance, recently told clients that TIPS don't correspond to inflation as well as derivative contracts tied to inflation expectations, according to a recent Bloomberg article.)

4. Foreign government bonds

Buying bonds issued by major developed countries including Germany or Japan is another safe way to best U.S. interest rates. Two-year German government bonds, for instance, yield 4.32%—170 basis points over the U.S. alternative. Stick to countries in the G7, though, says Merrill Lynch's Bernstein. Since underdeveloped countries can tend to have more volatile interest rates, rampant inflation, or less access to capital, the risk of government default is greater in those cases. "There's a big difference between major developed countries and emerging markets," says Bernstein. "The key thing is quality." Investors can buy individual government bonds through brokers or invest in mutual funds like the T. Rowe Price International Bond Fund (RPIBX), which invests primarily in high-quality bonds outside the U.S.

5. Shorter-maturity bonds

If investors want to bolster their portfolio's defenses, they don't necessarily need to tweak their stock-to-bond ratio. Instead they can emphasize bonds with shorter maturity dates in the fixed-income portion, where the risk of default is lower. "If you had started in bonds with a 7- to 10-year maturity and switch to the 1- to-5-year maturity range, you've immediately taken risk out of your portfolio," says Gregg Fisher, president and chief investment officer of Gerstein Fisher in New York. "And you still haven't reduced your stock market exposure." That way, investors don't have to absorb the capital gains taxes from selling off their stocks.

6. Options

Then there's the old-fashioned approach to stock insurance: options. Investors with long positions in equities can always put a floor on potential losses by buying put options, which rise in price if the value of the underlying stock declines. For instance, as of July 29, Apple (AAPL) common shares traded at $157.08. The asking price for a September 2008 put with a $140 strike price was $20.80, which means that, if the stock price fell below $140, an investor could offset the loss by exercising the option. But it's expensive. "You will eventually give up returns by owning the insurance," says Fisher. "But if it makes you sleep at night, it's definitely something to consider."

The better strategy, says Florida hedge fund manager Michael Levas, is selling covered calls. Using this tool, investors agree to sell the stocks they own if the stock value exceeds a future price, but if the stock value falls, and the option expires unexercised, they keep the option premium. Again using Apple as an example, an investor with Apple shares could sell a September 2008 call with a $160 strike price for $9.70 per share. If the price rises past $160, the investor would receive $160 from the sale of each share and pocket the additional $9.70 per share; if the price dropped, the investor would still hold onto the stock but pocket the extra $9.70.

Considering that roughly half of all options are never exercised, it behooves investors to be on the selling side, says Levas, founder and chief investment officer of Olympian Capital Management in Fort Lauderdale. "People who make money in options are the sellers," he says. "They're taking money in, and if the stock is called away, they've still made money on it." Investors can write covered calls by setting them up through brokers or financial advisers, says Levas.

7. Short-market funds

Another option is to go short. An investor with long positions in equities can always purchase short funds—which bet that the overall market will decline. Levas recommends investors take a look at ProShares' variety of exchange-traded funds like the Short S&P 500, which performs inversely to the S&P 500. Mutual funds that short-sell the market, such as the $1.2 billion Prudent Bear Fund (BEARX), can also offset long positions and shrink risk.

8. Consumer staples and dividend-paying stocks

Investors should remember that, over periods of five years or more, equities are still relatively safe. If you look to five-year periods going back to 1926, 90% of the time the stock market hasn't lost money, says Palisades' Bergman. "If you can mentally withstand the volatility over the next five years," he says, "stick with the stock market." The consumer staples sector is often seen as a good recessionary refuge, because "no matter what goes on we still eat, drink, and hopefully bathe," says Bernstein. "Consumer staples tend to hold onto money better," says Tim Crowe, managing director and chief executive of Anchor Point Capital in Coral Gables, Fla. U.S. portfolio managers still say the sector is underweighted, according to a recent fund managers' survey from Merrill Lynch.

Other relatively safe stocks in a recessionary environment are those of companies with high dividend yields. While a juicy dividend doesn't guarantee healthy financials (see Wachovia's 12.9% yield), high-dividend companies are generally less volatile than their growth-company counterparts. State Street Global Advisors offers an ETF (SDY) that tracks the Standard & Poor's index of 60 companies that have increased their cash dividend in each of the last 25 years. (S&P, like BusinessWeek, is owned by The McGraw-Hill Companies (MHP).)

9. Corporate bonds

More audacious investors still seeking a degree of safety can venture into corporate bonds, even in the financial sector, according to Tom Hayden, vice-president and director of investments at American Reserve Group in Dallas. Since record writedowns by big financial firms and plummeting stock prices have spooked the overall industry, higher-quality banks have been forced to pay more to borrow money, he says. Which means that there are deals to be had. Banks including Bank of America (BAC) and Wells Fargo (WFC) are too well-capitalized and "high quality" for their debt not to be "money-good," he argues. A 2015 Bank of America bond with an A+ rating from Fitch, a AA- from S&P, and an Aa3 from Moody's, yields 7.9% today. "Compared to owning equity in the company it's defensive," says Hayden. "But it's certainly a contrarian play."

10. Preferred Stock

Investors who want a stable income stream should look into buying preferred stock from corporations with good credit quality. Of course, "good credit quality" isn't what it used to be, so investors need to pay special attention to things like a company's cash reserves, its bond ratings, and its interest coverage ratio—its earnings before interest and taxes (EBIT) divided by its interest expense over the last 12 months.

High-grade preferred stock in solid companies offers two defensive advantages, says Olympian's Levas. First, preferred stock holders stand in front of common stock counterparts if a company liquidates or goes bankrupt. Second, "you're also getting a steady stream of income all the time," says Levas. "So for somebody concerned about current income that's a great option." Dividends are usually paid monthly or quarterly. Levas recommends preferred stock from insurance holding company Markel (MKV), since it yields 7.5% and the price has fluctuated very little despite turbulent financial markets. The company carries a BBB bond rating from S&P, and its EBIT was a healthy nine times its interest expense over the last four quarters.

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