As this volatile year heads to a close, there are three issues on the minds of every investor: the U.S. presidential election, the second stimulus bill, and COVID-19.
Each of these factors creates uncertainty for investors. And as you probably know, the market hates uncertainty.
The effects are obvious. We saw a down month in September and a highly volatile month in October. If there is a contested election result, we could see a worst-case scenario occur in November.
While traders love to see a lot of movement in the markets, most investors are more risk averse. That’s why you may want to consider allocating some of your portfolio to defensive positions.
Today, I’ll explain what defensive positions are… and four ETFs that will help you lower your portfolio risk.
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What are defensive positions?
A defensive position is an investment that provides protection from volatile markets and economic uncertainty. It can be any stock, bond, or commodity that offers stability when the market is under stress.
The best defensive positions exhibit lower volatility than the rest of the market. They also attempt to reduce the impact of falling markets.
The goal is simple: to keep your portfolio stable when the market hits a rough patch.
Defensive stocks typically come from companies with stable earnings. Ideally, a defensive stock should pay consistent dividends, regardless of the economy and the broader stock market. The best companies have steady demand for their products—in a good or bad economy—which keeps their earnings steady in volatile times.
Some investors prefer high-quality, short-maturity bonds to add stability to their portfolios. But stocks and gold offer better options for risk-averse investors right now. With interest rates sitting near historical lows, bonds simply don’t offer significant upside. Meanwhile, defensive stocks and gold can offer much better potential for capital appreciation.
Just keep in mind that these investments are not risk-free. And make sure you don’t completely change your investing strategy. These positions work well as part of an overall portfolio strategy allocation.
Examples of defensive positions
Instead of focusing on individual stocks, I’m going to focus on exchange traded funds (ETFs). Buying an ETF works the same as buying an individual stock. However, these funds own dozens (or even hundreds) of stocks, which means we get the benefits of diversification. And as you probably know, diversification is one of the best ways to reduce the volatility of your portfolio.
The consumer staples sector is a great area to find defensive stocks. This sector includes companies that focus on beverages, food, household products (like cleaning supplies), and personal products (everything from toothpaste to makeup). These products benefit from steady demand, since consumers buy them out of necessity, regardless of economic conditions.
These stocks typically generate steady cash flow and stable earnings during both favorable and unfavorable economic environments. The companies have predictable revenues and tend to pay out dividends. With Americans stuck at home for most of 2020, these stable products have become all the more essential.
My pick here is the Consumer Staples Select Sector SPDR ETF (XLP). This ETF invests in the 30-plus consumer staples stocks in the S&P 500. Its top holdings are all well-known blue-chip companies. For instance, its top holding is Procter & Gamble (PG), which sells Bounty paper towels, Tide detergent, and Pantene shampoo. The fund’s second-biggest holding is retail giant Walmart (WMT), where many people buy these products. The third and fourth top holdings are beverage heavyweights Coca Cola (KO) and PepsiCo (PEP).
For our second ETF pick, we want to focus on low volatility stocks. This strategy keeps you exposed to the stock market while reducing risk. Low volatility stocks include companies across a wide range of businesses. As their name implies, their key feature is low levels of historical volatility. In other words, these names don’t jump up and down as much as other stocks, especially in down markets. They can help to limit your downside during selloffs.
The best option here is the iShares Edge MSCI Minimum Volatility USA ETF (USMV). This ETF tracks the MSCI index of minimum volatility stocks located in the U.S. These stocks have comparatively lower risk profiles and lower volatility readings based on MSCI’s proprietary screening methodology. Top holdings include utilities company Nextera Energy (NEE), fast-food giant McDonalds (MCD), and communications firm T-Mobile (TMUS). These stocks have historically been less volatile than the broader market.
Gold is a popular defensive investment due to its reputation as a safe haven asset. Gold prices tend to rise in a fear-driven market. Gold isn’t correlated to the stock market. That means it offers diversification benefits, since its price movement doesn’t follow the stock market.
Gold also tends to go up when central banks have an easy money policy. And that’s exactly the current situation. With COVID-19 hurting economic activity around the world, central banks are desperate to keep their economies afloat. Pro-growth policies (like stimulus plans) create a bullish environment for gold price. Even better, gold can add some protection to your portfolio during a stock market selloff.
The easiest way to invest in gold is through the SPDR Gold Shares ETF (GLD). This fund follows the performance of gold bullion prices. It’s a convenient and cost-effective way for investors to get exposure to physical gold, which has benefited from the uncertainty caused by the coronavirus pandemic.
Utilities are another great area to find defensive stocks. These companies provide electricity, gas, and water services, which are necessities that people pay for regardless of the economy. These companies generate reliable revenue streams that create steady dividend payouts for investors. Many utility stocks offer high yields, which investors typically flock to during periods of market distress. This helps keep their value steady during volatile times. It’s also worth mentioning that utility companies typically rely on debt to fund their long-term operations. That means they benefit from low interest rates, which reduce their interest expenses.
A solid pick here is the Utilities Select Sector SPDR ETF (XLU). This ETF invests in more than two dozen utility companies that are part of the S&P 500. This fund has a 16% allocation to NextEra Energy (NEE), which is also a top holding in the iShares Edge MSCI Minimum Volatility USA ETF.
It’s not a deal-breaker, since NextEra is a great company. But investors should be aware of the overlap in holdings. The fund’s next-biggest positions are electric power providers Duke Energy (DUK) and Dominion Energy (D).
If you’re concerned about the many uncertainties hanging over the market as we head into the end of 2020, these four ETFs are a great way to ride out the storm.
By adding one or more of these ETFs to your portfolio, you’ll lower your risk compared to most stock index funds. It’s a great way to stay invested… while protecting yourself in a volatile market.
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