Many financial advisors argue that equities should be a part of any retirement plan. That's fine, but, even though stocks have increased in value over the long term, I worry about their potential volatility short term. In fact, I'm happy to give up a little upside potential in my stock portfolio in exchange for some downside protection. Therefore, in order to avoid losing sleep at night worrying amount how my stocks are performing, I have sought out defensive investment strategies, including the following, for risk-averse investors.
Sell Covered Calls
I sometimes sell covered calls on stocks I own to provide incremental income and limit downside risk. When I sell a covered call, I am giving the buyer the right to purchase the stock from me for a set period of time at a given price. For example, if I own 100 shares of stock A at $25 and, in October, sell a January covered call with a strike price of $27 at a price of $1, I will receive $100 today. If the share price is below $27 when the call option expires in January, I keep the stock and the $100. If it is above $27, I keep the $100, the call owner buys the stock at $27, and I miss out on some appreciation (although, unless the stock is above $28, I will profit from or be no worse off than if I didn't sell the call, excluding commission costs). Also, my downside risk in the stock is $1 less than it would be otherwise.
Invest in Dividend Payers and Dividend Growers
I invest in dividend-paying stocks that provide a stream of income, so that I am not solely reliant on capital appreciation for stock portfolio performance. I know that dividends matter, since historically they have contributed a large share of stock market returns. For example, based on data provided by Bloomberg, from 1990 through 2010, dividends accounted for 43% of the rise in the S&P 500 (http://www.darwinsmoney.com/dividend-stock-market-returns/).
Even better, I try to identify companies with rising dividends so that the income from my stock portfolio increases over time.
One caution about investing in dividend-paying stocks, I am wary of companies with extremely high dividend yields (annual dividend rate/share price) for two reasons. First, sometimes a very high yield reflects a depressed stock price as a result of fundamental problems at a company, which could mean that the dividend is at risk. Second, it takes more time and effort to research a high-yield stock to determine how safe the dividend is.
I diversify, both by company and industry. Diversification spreads risk and helps to limit the effect of a disappointing investment on overall portfolio performance, which can help to smooth my portfolio's performance over time.
Go on Defense
I seek out defensive stocks. Some stocks and some sectors (such as food companies and utilities) tend to be less economically sensitive and therefore to achieve more consistent financial results over time, which can help to reduce portfolio volatility. Their earnings growth may be slower than for more cyclical companies, but it also tends to be steadier, and they generally pay dividends.
Dollar Cost Average
I learned the advantages of dollar-cost-averaging for stock purchases when I participated in company stock-purchase programs in which I arranged to buy a set dollar amount of the company stock on a regular basis. The advantage was that I bought more shares for the same amount of money when the price was down and fewer shares when it was up. One of reasons that this strategy worked was that the purchases were automatic, which overcame my reluctance to purchase shares when the price was down for fear it would go lower.
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