Buyers don’t always plan for rough waters when the market is going up. But the best time to build a defensive plan for a stock allocation is before volatility hits.
Investors who want defensive stock strategies might think they have to give up the chance of making money in the long run to reduce volatility. But they might be surprised to learn that a plan focusing on stocks that lose less in a downturn can beat the market in the long run.
Most buyers understand risk without having to think about it. The famous capital asset pricing model (CAPM) from the 1960s laid out the framework. It showed that expected return was a function of both firm-specific risk and an asset’s vulnerability to the market as a whole. At its core, though, it’s based on a simple idea: buyers want to be paid for taking on more risk. If taking risks didn’t pay off, everyone would keep their money in cash and call it a day.
Risk in a Choppy Market: Relative Risk vs Absolute Risk
Too often, financial managers are too focused on relative risk, which means they constantly compare their performance to a market-cap-weighted benchmark index; this can go against what buyers care about, which is how well an investment helps them reach their long-term financial goals.
During market instability, like the 2022 downturn, the problem is tough to solve. Last year, the S&P 500 fell 18.1%, and the MSCI World fell 16.0% in local currency terms because inflation stayed high and the economy slowed down. Even though stocks have risen strongly in 2023, there is a clear and present risk of more volatility because the macro economy is still uncertain, and people are still worried about inflation and high-interest rates.
Buyers don’t always plan for rough waters when the market is going up. But the best time to build a defensive plan for a stock allocation is before volatility hits; this goes against CAPM and other rules of thumb about risk and return. But more and more study shows that investors can take less risk and still beat the market over time by investing in low-volatility stocks as part of a carefully chosen portfolio. By doing this, buyers can gain the confidence they need to stay invested in stocks even when times are rough.
There are different ways to plan for low fluctuation. We think that a good defensive strategy should be based on the fundamentals of a company and focus on companies with good quality (consistent cash flows and measures of profitability like return on invested capital), stability (low volatility of returns compared to the market), and attractive pricing that makes them less likely to be affected by big swings in the market; this is what we call the QSP world.
Companies in traditionally defensive sectors like consumer staples and utilities are good examples. However, the QSP universe includes companies with great business models in every sector of the economy, which can be found through fundamental study and careful stock selection.
For example, “quality compounders” companies have strong business models and steady earnings backed by good capital management and good ESG behaviour. Intangible assets like names, culture, R&D, and patents can also be precious, especially in times of stress. These characteristics make it possible for steady growth drivers to lead to compounding earnings gains through market cycles.
The key is to limit the ups and downs.
Companies like these can help low-volatility strategies reduce their downside capture, or their exposure to falling markets, while still getting some of the market’s gains. In the same way that it’s easier to get to the top of a hill if you start halfway up, stocks that lose less when the market goes down have less ground to make up when the market goes up again. So, they can better build on those higher returns when the market goes up again, improving their long-term success.
This idea can be shown by plotting a so-called 90%/70% portfolio against a global measure of investment-grade stocks, the MSCI World measure. This hypothetical strategy is called “90%/70%” because it would get 90% of the market’s gains when it goes up and only 70% as much when it goes down.
Using data from the beginning of the index on March 31, 1986, to the end of June 30, 2023, we found that our hypothetical 90%/70% portfolio would have yearly returns that were 3.1% higher than the MSCI World Index during this time, with less volatility.
But here’s the catch: investors would have to accept that a 90%/70% portfolio doesn’t behave like the market to get these long-term gains.
That’s an easy pill to swallow when the market moves back and forth like last year. After all, this low-volatility approach would only expose investors to 70% of the market’s downside during market downturns. The real test comes when the market goes up because 90%/70% would do worse than the market. You have to pay this price to beat the market over the long run.
Recessions are a test of low volatility.
So, how well would a low-volatility QSP approach do during a recession?
Studies show that during downturns, S&P 500 stocks that were in the highest quintile for QSP characteristics did pretty well. For example, during the 1973–1974 recession caused by the OPEC oil embargo, the top quintile of the S&P 500 in terms of quality, security, and price fell by 36.9%, less than the S&P 500’s 42.6% drop. And during the slump of 1980–1982, when the market fell by 16.5%, QSP stocks went up by 8.5%.
Redefining Offence and Defence in Equities
At the same time, buyers in defensive stocks may worry about falling behind in rising markets, like this year’s technology-driven rally. Tech stocks can be a big part of a portfolio with low volatility.
Many sound, profitable tech companies that work behind the scenes don’t have to deal with the same risks as the big companies that deal directly with customers. These include less well-known technology enablers and payment-services companies with long-term business models and large, steady income streams. Even though it seems odd, certain technology stocks with these traits have defensive qualities and give investors a more significant share of the market’s upside. In other words, the usual roles of offence and defence in dividing equity are changing.
Low-volatility strategies can be customised with another active system to meet an investor’s risk tolerance, time horizon, and investment goals in any market or macroeconomic situation. Even though it’s not easy to make a perfect 90%/70% portfolio, the main idea is to lower exposure to market swings that can hurt long-term returns.
Through fundamental study, it’s possible to assemble a portfolio of well-priced companies with essential signs of quality and stability that can do well in rallies and handle short periods of volatility. In times like these, buyers may need a smoother ride.
