As investors, it's handy to understand how to manage our risk and bolster our portfolio for market turbulence. An easy and accessible way to start is by familiarizing ourselves with protective or defensive assets.
What makes an asset protective?
Defensive investments are ones that historically have been uncorrelated or negatively (or inversely) correlated with the stock market.
- Positive correlation: The asset's price rises in value when stocks go up in value
- Negative correlation: The asset's price rises in value when stocks drop in value
- Uncorrelated: The asset's price is not related to the stock market. For example, when stock prices are dropping, these assets could be staying the same
These assets also protect us from inflation. In times of higher inflation, our cash becomes less valuable over time. A $1 doesn't buy as much stuff as it used to. Thus, an investment that will generate a consistent return helps us keep our purchasing power so we can keep buying the same amount of stuff.
Examples of protective assets
Popular protective assets include bonds, gold, real estate, and other alternatives. As we look at these four asset classes, it's helpful to compare their price movements to stock market selloff in March 2020 due to the COVID pandemic.
While bond prices are generally negatively correlated with stocks, bonds also pay steady income to the investor. For these benefits, bonds are the most popular protective asset. Note, not all bonds fit the defensive asset description. Protective bonds are those with high credit ratings, such as US treasury bonds or local municipality bonds. Lower credit rating bonds such as corporate bonds are more correlated to stocks in times of trouble.
For instance, suppose the economy is heading into a recession. In that case, investors who lose confidence in a company's earning potential will also doubt if the company can make the interest payments due or return the money borrowed. As a result, the investors also sell the bonds of the company.
We can see the negative correlation during the March 2020 COVID market crash. The blue line represents the S&P500 while the green graph is $VGLT, a total bond ETF by Vanguard. As the S&P 500 lost nearly 30% of its value, the price of $VGLT steadily increased.
Gold and other rare commodities also serve as protective instruments.
For example, the jewelry and electronics industry supports gold and rare metal prices during all economic cycles since gold is a great conductor used in computer chips.
$GLDM, a gold ETF by State Street Advisors, lost some value during March, similar to stocks, but recovered its value much sooner than the S&P500.
While considered a protective asset by some, real estate is not as reliable compared to bonds and gold. An easy way for everyone to invest in real estate is through a REIT (Real Estate Investment Trust).
REITs represent a basket of real estate properties that we can purchase, just like a mutual fund or ETF. In many cases, a REIT may own commercial real estate. They are significantly impacted during recessions when companies shut down, and fewer surviving businesses maintain large offices.
The stock market often serves as a canary in the goldmine for the residential housing markets. Trends in residential real estate tend to lag stock markets by about 12 months. So if the economy turns into a recession, home prices drop a year after stock prices drop. The loss in value affects both investors in REITs that focus on multi-family homes and property owners.
We can see the correlation in the chart above between $AMT, the largest REIT by market cap, and the S&P500. In March of 2020, the REIT lost as much value as the overall stock market. Investors in luxury real estate may have more protection since these homes are always in high demand. Unfortunately, there aren't a lot of investment options available for luxury homes.
Crypto enthusiasts have been making the case that digital assets or cryptocurrency can replace gold as a store of value. Specific crypto like Bitcoin is designed to have a limited total supply and be noninflationary. However, it seems bitcoin is still strongly correlated with the S&P 500 when we look at the price for BTC in March 2020. The correlation may change in the future as more countries and people start adopting crypto.
The graph above shows the correlation between the S&P500 and BTC. The periods where the line chart is above 0% mean that BTC is positively correlated with the aggregate stock markets.
Liquidity crunches or irrational selling during extreme market panics can cause these protective assets to be ineffective. In these rare events, all assets become correlated as investors rush to convert everything into cash.
The most notable liquidity crunch was black Tuesday, leading up to the Great Depression.
To combat panic selling, regulators have implemented circuit breakers that freeze trading for a specified time. The break from trading gives people a chance to regain rationality and is used by exchanges worldwide.
While liquidity crunches occur occasionally, you shouldn't throw the baby out with the bathwater. Protective assets like bonds are great additions to your portfolios. When considering protective assets, the beta measurement is a good rule of thumb to follow. Defensive assets will have a beta far below 1, while risky investments will have a beta that's larger than 1.
Besides protective investments, it's possible to buy "insurance" for our investment value using put options. However, it's a good idea to learn about derivatives and stock options before trying to use them.