Given the recent uptick in market volatility, it may be time to think about playing a little defense.
Of course, a portfolio strategy that employs both offensive and defensive assets is prudent no matter the prevailing market conditions. For proof positive, look no further than the Great Recession, during which investors in traditionally defensive assets—including cash investments, precious metals and U.S. Treasuries—generally saw positive returns, even as their domestic and international stock investments plummeted (see “Bucking the trend,” below).
Bucking the trend
In 2008, defensive assets posted positive returns as domestic and international equities suffered debilitating losses.
Source: Schwab Center for Financial Research and Morningstar. Data from 01/01/2008 through 12/31/2008. Asset-class returns are represented by the following indexes (from left): Bloomberg Barclays U.S. Treasury 10 Year Index, Bloomberg Barclays U.S. Agency Bond Index, S&P GSCI Gold Index, Bloomberg Barclays U.S. Short Treasury Index, Russell 2000® Index, S&P 500® Index, MSCI EAFE Gross Return Index and MSCI Emerging Markets Gross Return Index. Past performance is no guarantee of future results.
Here are four asset classes that can help stabilize your portfolio during a market correction—and Schwab’s general guidance regarding your exposure to each.
1. Cash and cash equivalents
Why: Putting a chunk of your portfolio in money market funds or certificates of deposit (CDs) won’t generate much in the way of interest, but these products do offer liquidity in case of emergency, flexibility as new investment opportunities arise and stability relative to other asset classes. What’s more, CDs are insured by the Federal Deposit Insurance Corporation (up to $250,000 per depositor), so you won’t lose your money even if the issuing bank fails.
How much: Generally speaking, even the most aggressive investors should hold at least 5% of their portfolios in cash and cash equivalents; for conservative investors, that allocation may be closer to 30%.
2. Gold and other precious metals
Why: Because of its finite supply, gold tends to maintain its value even during periods of economic upheaval. Other precious metals may also hold up well, though that can depend in part on what they’re used for. (Platinum, for instance, is used in the catalytic converters found in many automobiles, whose sales tend to rise and fall with the broader economy.) Even during a bull market, the prices of precious metals tend to move independently of stocks, enhancing any potential diversification benefits. And because their prices tend to rise along with inflation, they may also provide a hedge against broad cost increases. That said, precious metals’ prices can be affected by world events, import controls and other external risks; they also tend to be more volatile than those of other defensive assets, which may make them unsuitable for risk-averse investors.
How much: Precious metals, together with other commodities and real estate, should account for as much as 9% of an aggressive portfolio; less aggressive investors may want to limit such exposure to 5%, while the most conservative investors may want to avoid the asset class entirely.
3. U.S. government-related bonds
Why: These securities are issued by government-owned corporations (GOCs), such as Amtrak, and government-sponsored enterprises (GSEs), such as the Federal Home Loan Mortgage Corporation, otherwise known as Freddie Mac. Unlike federal agency bonds, which are backed by the full faith and credit of the U.S. government, GOC and GSE bonds are the sole responsibility of the issuer, meaning the federal government is under no obligation to save them from default. This can make these bonds riskier than Treasuries, and investors are offered incrementally higher yields as a result.
Like Treasuries, agency bonds’ prices fluctuate in response to interest rates, which could affect their price on the secondary market. Furthermore, many agency bonds are callable, meaning the issuer may choose to pay back the principal before the maturity date, thereby cutting coupon payments short.
How much: U.S. government-related bonds, together with Treasuries (see below), should make up anywhere from 10% to 70% of your portfolio, depending on your risk tolerance. However, the most aggressive investors may want to avoid such exposure altogether.
4. U.S. Treasury bonds
Why: Treasuries are backed by the full faith and credit of the U.S. government, making them one of the most stable investments for protecting capital. Intermediate-term Treasuries (those with maturities of 3 to 10 years) have held up particularly well during downturns, registering positive total returns during all but one of the 28 bear markets since 1929.1 Should the Federal Reserve continue to push rates higher, Treasury prices on the secondary market may decline. That’s likely of little concern to investors who plan to hold their Treasuries to maturity but is a risk nonetheless.
How much: See “U.S. government-related bonds,” above.
Finding your mix
Ultimately, your exposure to each of these asset classes should depend upon your personal risk tolerance, time horizon and market outlook. A qualified financial advisor can help you determine the right mix for your needs.
1Mark Hulbert, “If the Bear’s Near, Which Assets Protect You?” wsj.com, 09/08/2015.