Defensive-Minded Investing
Invest with a similar mindset to that of a strong amateur tennis player – defensively.
Defensive-minded investing is an approach that focuses on risk first and return is secondary. By risk, I am referring to the possibility of loss of capital, perhaps permanent, and if you don’t pay attention to it, or you are simply an offensive-minded investor looking to hit home runs, it’s possible that in certain market conditions your portfolio may not survive.
If your investment objective is both preservation of capital and moderate growth, as it is for most of my clients, there is a need to constantly weigh both objectives. Let’s face it, they are opposites – you cannot have growth while only preserving capital (assuming no risk whatsoever), so there has to be a balance and astute investment advisors are constantly trying to find the appropriate balance given the risk profile of their clients and their investment objectives. Most of my clients have the investment objective of wealth preservation with moderate growth and income potential with the goal of generating returns sufficient enough to outpace inflation and taxes. This sounds reasonable, but it is challenging. In order to achieve these objectives, my management approach has to be defensive – trying to limit downside risk and losses with the goal of protecting wealth at market extremes (when valuations become stretched in the late stages of a bull market).
An excellent sports metaphor to help better understand the approach taken by a defensive-minded investment manager was presented by Charles Ellis in an article published in 1975 in The Financial Analysts Journal. Mr. Ellis presented his thoughts on the subject by using work done by Dr. Simon Ramo, showing a comparison of professional and amateur tennis players. He described this comparison, which was analyzed by Dr. Ramo in Extraordinary Tennis for the Ordinary Player. In the article, he referred to professional tennis as a “winner’s” game and amateur tennis as a “loser’s” game.
The professional tennis player typically reaches such a high level of play and continues to win, by hitting shots his opponent can’t return. These “winners” determine the outcome of the match and the player who hits the most winners will be victorious. The opposite is true in amateur tennis. If you watch a typical match at your club you’ll notice that because most of us lack the skills necessary to hit winners, the amateur who can simply minimize or control his or her “losers” will be victorious. The winner at the amateur level can simply try to keep the ball in play long enough for the opponent to make a mistake. By focusing on defense and not losing the point, the defensive-minded amateur will typically beat most players – wear them down and basically let them beat themselves.
Mr. Ellis applied the thoughts of Dr. Ramo to investing and showed that an investor’s focus should be to not necessarily go for winners (like the adroit professional tennis player), rather, to try to avoid losers (like the steady amateur tennis player). This defensive approach appeals to me as a money manager, and is much more likely to allow you to be successful investing in all market conditions – bull and bear markets. Bottom line, there is much we cannot control when investing, but we can maintain a focus on defense to minimize risk.
If one pays attention to risk, with the goal of not losing money first (return is secondary), it is quite possible to keep portfolio performance close to the market (i.e. Dow Jones Industrial Average) in good times and hopefully perform better (lose nothing or much less than the averages) when markets are in a prolonged decline (bear market). My experience has shown that the vast majority of investment managers often lag the indices during strong bull markets and those who adhere to defensive-minded strategies may trail the indices by even more. But, those managers who focus on risk control, particularly when stock valuations become extreme, will be rewarded with better overall performance on a risk-adjusted basis, when comparing returns throughout an entire market cycle.
So, what type of investor are you? Are you offensive-minded with an aggressive approach, hoping to hit a home run? Or, are you defensive-minded with the goal of limiting losses and controlling risk? Are you content hitting singles and doubles? I will not work with investors who are always focused on offense because I know that when markets become difficult it will be impossible to keep the aggressive-minded investor happy. The high returns he or she was shooting for will turn into losses and a continued aggressive approach (that is the nature of this investor) will show repeated losses throughout a lengthy bear market.
True, the investor who is only focused on defense at all times and takes almost no risk will earn minimal returns. Those returns in our current low-yield environment will certainly not even allow you to keep pace with inflation. So, there has to be some compromise. There has to be a balance between trying to preserve wealth, but also show moderate growth. I believe it is possible to play defense, but occasionally be more offensive-minded if opportunities and valuations warrant it. You must have some “offense” in your portfolio in order to achieve growth, but it must be intelligently applied depending on market conditions and valuations. It is an ongoing process and those who are not willing to put in the work will fail.
In my opinion, a defensive approach to investing makes sense for all investors and most certainly for retirees or those nearing retirement. If you try to control risk and avoid terrible bear market losses, you’ll have fewer sleepless nights and your returns can still be consistent enough to allow you to be financially comfortable throughout retirement. Yes, you may miss out on some excitement near the end of a bull market when valuations are extreme yet making money seems so easy (bubble territory), but if you aim to invest defensively and minimize drawdowns, you stand a good chance of achieving your investment goals.
Under no circumstances does the information in this column represent investment advice or a recommendation to buy or sell securities.
