Defensive Investing for a Volatile Stock Market
Types of Stocks You Might Want to Consider When Fear Runs High
When volatility strikes Wall Street, many investors seem concerned about their portfolios. As a dyed-in-the-wool value investor, I view these events as opportunities to pick up more shares of my favorite companies at bargain prices. However, it's understandable for those who aren’t professional investors, or who take a different approach to acquiring securities, to get nervous.
After a recent stock market correction, a friend of mine asked me what kind of portfolio I would construct for someone who wanted to own equities (stocks) but was keen on enjoying some insulation from price gyrations. As we had a conversation over coffee, I started thinking that the information might be useful to some of my readers. Here's an overview of some of the things that would fit the bill.
Stocks With Strong Dividend Yields
The first, and perhaps most powerful defense is a stock with healthy earnings and a relatively good dividend payout ratio and dividend yield, especially when compared to the yield that is available on the relatively risk-free United States Treasury bond.
Investors often compare everything to this so-called “risk-free" Treasury rate. When you buy a debt obligation of the United States, you can be fairly certain that you are going to get paid. As the wealthiest nation in the world, all the U.S. government has to do is raise taxes or sell off assets to pay its debt.
When the dividend yield of a stock is the same as the Treasury bond, many investors would prefer to own the former. You get more cash from the dividend yield because of favorable tax treatment and the capital gains generated from an increasing stock price.
Here’s how it protects you during a down market: As the stock price falls, the dividend yield goes up because the cash dividend is a larger percentage of the purchase price of each share.
A $100/share stock with a $2 dividend would have a 2% yield.
At $50/share, the same $2 dividend would have a 4% dividend yield.
In the midst of a market crash, at some point the dividend yield becomes so high that investors with excess liquidity often sweep into the market, buying up the shares and driving up the price. That’s why you typically see less damage to high dividend-paying stocks during down markets.
Dividends are not guaranteed to rise or stay the same. If a company's profits decrease due to declining purchases or an economic downturn, dividends may be cut. Some companies may go bankrupt or dissolve.
Consumer Staples and Blue Chip Stocks
True investors are interested in one thing: Buying companies with the highest net present value earnings at the most attractive price possible. In strained economic times, the stability of profits is extremely important.
Often, the most successful stocks are those that have durable competitive advantages. These consumer staples sell things such as mouthwash, toilet paper, toothpaste, laundry soap, breakfast cereal, and soda. No matter how bad the economy gets, it’s doubtful that anyone is going to stop brushing their teeth or washing their clothes.
Never invest any capital in equities that you might need within the next five years.
Finding these companies isn’t hard. They are often known as blue-chip stocks and make up the Dow Jones Industrial Average. They include household names such as 3M, Coca-Cola, IBM, McDonald's, and Pfizer, among others. They often have extremely large market capitalizations.
Companies With Share Repurchase Programs
Some companies regularly repurchase enormous amounts of their own shares. In a falling market, this can help reduce pressure because, as the stock is sold, the company itself is often standing by with its checkbook open.
If the stock does become undervalued, long-term shareholders benefit from these repurchases, as the enterprise is able to reduce the total shares outstanding far more quickly as a result of a lower stock price, increasing future earnings per share and cash dividends for the remaining stock. When things turn around, the stock recovers because the shares remaining get a higher boost.
Stocks Trading at Reasonable Valuations
Of course, if you only buy a diversified basket of stocks that traditionally have characteristics associated with value investing, the odds are good that you will emerge from the wreckage unscathed over the long-term. Value investing includes seeking out stocks with
- Low price to earnings ratios
- Low price to book ratios
- Low price to sales ratios
- Diversified operations
- Conservative balance sheets
For most investors who lack experience, value investing is best achieved through a low-cost index fund.
The Bottom Line
If you don’t have the ability to do a deep analysis of the factors above, it's best to have broad diversification in your stock portfolio. Consider keeping a portion of your portfolio in international investments by investing in a highly rated, low risk global mutual fund or index fund.
If you can’t handle price volatility, consider reducing the overall gyrations of your portfolio by including a substantial bond or fixed income component. Although this might lower your returns over subsequent decades, if it reduces the chances of selling everything in a panic, it can provide a workable compromise.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
S&P Dow Jones Indexes. "The Changing Down Jones Industrial Average." Accessed March 20, 2020.