When volatility strikes Wall Street, many investors become concerned about their portfolios. However, a market downturn can often be an opportunity to pick up more shares of valuable companies at bargain prices, as long as you are investing in stocks that can carry you through an unpredictable market.
This type of investing, which can help your portfolio weather changes in the market without losing too much value, is known as defensive investing.
Learn what type of investments to make to construct a portfolio of equities (stocks) while maintaining some insulation from price fluctuations in a volatile market.
Stocks With Strong Dividend Yields
If you are making defensive investments, you'll want to find stocks with:
- Strong earnings
- A reliably good dividend payout ratio and dividend yield
To find these, you can compare the dividend yield to the relatively risk-free United States Treasury bond. This rate is often considered a benchmark for finding valuable dividend-paying stock.
Treasury bonds are often called “risk-free" because the United States government can always raise taxes or sell off assets to pay its debt.
When the dividend yield of a stock is the same as the Treasury bond, it is often smarter to own the stock. You get more cash from the dividend yield because of favorable tax treatment and the capital gains generated from an increasing stock price.
This 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.
- At $100 per share, a stock with a $2 dividend would have a 2% yield.
- At $50 per 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, dividends may be cut, or the company may go bankrupt or dissolve.
Consumer Staples and Blue Chip Stocks
The core strategy of investing in stocks is to buy 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.
The most stable stocks are often those with durable competitive advantages. The either produce or sell consumer staples such as:
- Mouthwash and toothpaste
- Toilet paper and facial tissues
- Detergents and soap
- Breakfast cereal, milk, and other staple groceries
- Insulin, aspirin, and other common medications
No matter how bad the economy gets, it’s doubtful that anyone is going to stop brushing their teeth or washing their clothes. That means that these companies are unlikely to go out of business, even during a market downturn.
These companies are often known as blue-chip stocks, and many of them make up the Dow Jones Industrial Average. They often have extremely large market capitalizations and include household names such as:
Companies With Share Repurchase Programs
Some companies regularly repurchase large 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. The enterprise is able to reduce the total shares outstanding far more quickly as a result of a lower stock price, which increases 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
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
Value Investing and Mutual Funds
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.
For most investors who lack experience, value investing is best achieved through a low-cost index fund that invests in shares of many companies at once.
If you already have a good blue-chip index fund, you can also consider adding to your portfolio
- International investments, via a low risk global mutual fund or index fund
- Substantial bond or fixed income component
Although this might lower your returns over subsequent decades than investing in equities alone, it can provide a great deal of stability to your portfolio by balancing out your losses during a volatile market.