Building a portfolio, part 2: Defense first

This is the second part in the Building a portfolio series of articles. The first part dealt with making a decent investment plan. After this is done the actual investing can start. As mentioned in the previous article: it’s always a good idea to have some low risk investments with good liquidity in your portfolio. This article will cover the defensive part of a portfolio and why it’s important to start here.

Why the defensive part is important

Most people start investing to earn money. This goal is as clear as it is difficult. Risk and reward are always proportional to each other, which means any investor needs to take a certain risk to earn his desired return on investment. Before trying to earn money, trying not to lose money should be the first priority. This is where the defensive part of a portfolio is important. Even in severe bear markets (meaning falling prices and overall pessimism dominates) the defensive part ensures losses are kept to a minimum.

The defensive part of a portfolio is also fairly easy to setup. Using investment categories with good liquidity and low risk doesn’t require a lot of research. Setting up defenses is the perfect start, especially for beginning investors. It introduces the investor to the open market, before wandering into more risky territories.

How to earn money by being defensive

For the defensive part of my portfolio, I personally use the following products:

  • Cash
  • Investment grade (low risk) bonds and related ETFs
  • Certain (dividend) stocks and related ETFs

Some people might find it weird that managed funds are not on this list. In my opinion it doesn’t make sense to invest in managed funds when related ETFs have lower periodic costs. It would be fair to include managed funds if these performed better than ETFs, but several studies have shown that is not the case. In many cases managed funds severely underperform versus simple index trackers. For more information about underperforming funds, look at The Art of Investing and Portfolio Management by Cordes, O’Toole and Steiny; The Stock Market Universe by Bogle or The Myth of the Rational Market by Fox.

When done right the defensive part not only ensures losses are kept to a minimum, but it can also be used to earn money. The three categories/products mentioned above give the investor three methods for this. Cash can be put on a savings account, which ensures the investor periodically gets interest over his funds. The same goes for investment grade bonds, of which the bond issuer is obliged to pay the bond holder interest. Lastly ETFs and stocks, when chosen right, give stable dividend. Although the risk with stocks and related ETFs might be too high to count these products as truly defensive, they can still be useful. Just be careful to keep the relative amount of stocks vs cash/bonds low (lower than 20%). Of the three methods to earn money, keep in mind that dividend is not a given right. Not every company shares its profits to shareholders every year. Even a company with a good reputation when it comes to dividend payments might suddenly decide to stop if times are poor.

ETFs also let an investor easily diversify, which is another great strategy when building an investment portfolio. This topic will be covered in the coming part of this series…

Conclusion and outlook

The defensive part of an investment portfolio has a higher priority than the offensive part. Before trying to earn money the first priority of a beginning investor is to not lose money. The defensive part ensures that losses are kept to a minimum in overly pessimistic markets. The following article in this series will cover another important strategy when building a portfolio: diversification.

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