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Your Investment Portfolio: Time To Play Defense?

They say “defense wins championships” when it comes to which side of the football is responsible for securing the win in the Superbowl. It’s impossible to lose if the other team can’t score. The same concept can be applied to investing. A defensive stance in investing- one which attempts to limit losses as opposed to always trying to maximize gains- is a more conservative way to build wealth. So it is time to de-risk your portfolio?

While there is no crystal ball to tell us when we need to be more conservative, the market sometimes provides warning signs which shouldn’t be ignored.  One sign is the divergence between economic policy uncertainty and the low level of implied volatility in the equity market. Uncertainty over taxes, trade, regulatory reform and geopolitics is at a 17 year high. Usually, this coincides with more risk priced into the equity market. But not today.

The above chart shows a large divergence between equity volatility, measured by the VIX Index, and global policy uncertainty, measured by an index created by professors at Northwestern University, Stanford and the University of Chicago. Historically, the relationship has been quite tight. Higher economic policy uncertainty is coupled with higher equity volatility. The two series began to diverge in the middle of last year and now provide mixed signals as to the outlook for risk in the market.

Taken by itself, this is not a reason to make a major adjustment to your portfolio. One needs to examine other indicators, like valuations and investor sentiment, to get a more complete understanding of the level of risk in the market. It turns out these indicators are also flashing warning signs.

If your portfolio is highly sensitive to a continuation of the strong equity market performance since the November elections, it might be a good time to rebalance to a more conservative allocation. There are three ways investors can adjust their portfolios to a more defensive posture.

The first is probably the most obvious: tweak the asset allocation mix in your portfolio by reducing equity exposure and increasing the position in cash or fixed income. Trying to de-risk by making adjustments within the equity market is not sufficient. Switching to defensive companies, sectors or investment factors does not reduce your equity risk- and many of these investments are already trading at premium valuations relative to history. Also, increasing the fixed-income component does not mean you necessarily have to load up your portfolio with 30-year bonds. Short -term investment grade municipal or corporate bonds will do the trick.

Diversification is another way to de-risk a portfolio. Increasing exposure to international equity and fixed income markets should lower the overall level of risk without reducing potential upside. International equity markets- both developed and emerging markets- have underperformed the US market over the last several years, We don’t know when this trend of US market outperformance will end, but we can be certain it won’t last forever. More importantly, from a risk perspective, adding exposure to different countries and regions tends to lower portfolio volatility. 

The third way investors can reduce portfolio risk is to add an alternatives bucket, which is missing in many investors asset mix. Alternatives can be long-short mutual funds, systematic trend following CTAs, or other strategies with a low correlation to the broad equity market. These strategies are often designed to have performance which is not dependent on the short-term direction of the equity market. It’s true many alternative investments have underperformed a buy and hold equity strategy, but it is unfair to compare returns between the two when the stock market has only gone in one direction, having just completed its 8th consecutive year of positive performance. 

As the great David Tepper says, “there is a time to make money and a time to not lose money.” In other words, there is a time to play offense and a time to play defense. Investors need to be able to play both sides. High levels of uncertainty can be good if it means buying or holding assets which are appropriately priced for downside risk. It’s not good when valuations are high, investor sentiment is overwhelmingly positive, market internals are diverging and the market only seems to care about what can go right and not what can go wrong. It’s time for the defense to take over.