Defense Can Be the Best Offense
Why Now May Be the Right Time to Lower Portfolio Risk.
Long-term investing is built on the principle that time in the market typically beats timing the market. But that doesn’t mean investors should stand pat when the risk of a sustained correction—or worse—appears to be rising.
Today’s environment presents several reasons to be cautious.
U.S. stock valuations remain elevated by multiple historical standards. The Shiller CAPE ratio recently reached its second-highest level since 1871, while the excess CAPE yield—a valuation metric that adjusts for inflation—projects an annualized return of just 1.4% for U.S. equities over the next decade.
Forward-looking estimates from TMC Research point to a more subdued outlook. Our 10-year median forecast for U.S. stocks, based on five independent models, is less than half the trailing 10-year return. While no forecast is perfect, the weight of evidence suggests a high likelihood of more modest returns ahead.
Some analysts see stagflation, where the economy slows and prices rise at the same time, as a growing threat. Depending on when you were born, you may recall the toll stagflation took on the markets in the 1970’s.
Geopolitical and macroeconomic risks also remain elevated. Rising tensions in the Middle East, the ongoing war in Ukraine, and increasing uncertainty around China’s posture toward Taiwan—home to one of the world’s most critical semiconductor foundries—all point to a fragile global environment.
In light of these factors, some investors may find it prudent to adopt a more defensive posture than usual—at least until market conditions begin to normalize.
Approaches to Tactical Risk Management
For investors who see merit in trimming risk, several tools are available. Examples include the following.
Rebalancing Overweighted Equity Allocations
After years of strong equity performance, many portfolios have drifted above their target stock allocations. Rebalancing back to your model portfolio—by trimming equities and adding to fixed income or cash—is a simple but effective way to bring portfolio risk back in line.
Dialing Down Equity Exposure
Temporarily reducing your portfolio’s equity allocation and reallocating to government bonds, money market funds, or certificates of deposit is a straightforward way to reduce risk. Moreover, the opportunity cost may be relatively low if forecasts for subdued equity returns prove accurate. For example, a 3-month Treasury bill is currently yielding 4.40%, which is more than 80% of the 10-year expected return for the stock market, based on TMC’s median estimate.
Adding Exposure to Downside-Resilient Assets
Another way to deal with an elevated risk environment is to invest in asset classes that have historically held up well during market drawdowns. Examples include:
- Treasury bonds, particularly Inflation-Protected Securities (TIPS), which help preserve real purchasing power during inflationary shocks.
- Precious metals, such as gold, silver, and platinum, which have historically served as stores of value during financial stress.
- Low-volatility ETFs, which typically decline less than the overall market.
- Defensive equity sectors, such as utilities or healthcare.
- Managed futures or tail-risk strategy ETFs, offering exposure to sophisticated risk management in a liquid, ETF-based format.
Selective use of Options
For investors seeking downside protection without selling, put options may offer a practical solution. For example, purchasing a put on the S&P 500 Index allows an investor to retain equity exposure while limiting potential losses below a defined threshold.
While options come with a cost (the premium), they can serve as an efficient hedge, particularly in taxable accounts or portfolios with concentrated positions.
Conclusion
The stock market usually goes up but downturns can last several years.
Investors with a high tolerance for volatility and the discipline to ride out deep drawdowns may not need to adjust their portfolios during periods of elevated risk. However, behavioral finance research has long shown that investors often struggle to stay the course during drawdowns.
That’s why a tactical approach to risk management may help improve long-term outcomes. The right defensive strategy will vary based on individual circumstances, tax sensitivity, and overall objectives. A plan for managing risk before panic sets in can help investors avoid selling near the bottom.