Published by Nicholas McCullum on May 11th, 2017
The current bull market has lasted more than eight years. This is longer than the typical bull market and has led many investors to question whether the next major recession is coming quickly.
Those that are worried about the next recession will naturally position their portfolio in a defensive manner. This typically means paying down margin debt, holding extra cash, and purchasing low-risk instruments such as fixed income securities.
However, being too defensive in anticipation of a recession can have a negative impact on overall portfolio returns.
“Far more money has been lost by investors trying to anticipate corrections than has been lost in corrections themselves.” – Peter Lynch
This article will describe 3 mistakes that investors make while implementing a defensive portfolio strategy.
It is widely known that holding cash offers a negligible return on investment, even if said cash is invested in an interest-bearing money market account.
This is largely due to the low interest rate environment. Consider the following:
- The current 3-month U.S. treasury bill yield is 0.80% (compared to a long-term average of 4.43%)
- The current 10-year U.S. government bond yield is 2.30% (compared to a long-term average of 6.29%)
With that said, the poor returns of money market instruments are still much preferable to equity investments if the market is declining by 30%+. Thus, it might seem logical for investors to close positions and hold cash if they anticipate a recession in the near-term – though this is not the best approach.
The trouble with holding cash in anticipation of a bear market is that investors cannot accurately predict the future. Holding cash while markets continue to rise means that you’re missing out on potential investment returns. I will use two examples to illustrate this.
After the global financial crisis of 2008-2009 eroded billion dollars of wealth, many investors avoided the financial markets (holding cash instead) while the S&P 500 surged by nearly 300% (including dividends).
A similar trend was seen as recently as 2014. As the S&P 500’s price-to-earnings ratio expanded significantly due to improved consumer confidence and a generally bullish sentiment on the economy, many investors sold securities. These cash-holding investors cited overvaluation and a high probability of poor future returns as reasons to avoid equities.
These same investors watched with a frown from the sidelines as the S&P 500 delivered an additional cumulative return of ~38%.
While these are extreme examples, they provide learning opportunities and can be generalized to more moderate examples. Specifically, cash can hurt a portfolio’s returns even if it’s not the sole component of the portfolio. Holding a portion of cash instead of remaining fully invested can significantly impair long-term investment returns.
The following diagram compares the time-weighted returns of a dividend stock portfolio that held varying levels of cash in anticipation of a future recession that never happened.
Clearly, holding cash in anticipation of future downward movements in asset prices has not rewarded shareholders in recent history. While this has some look-ahead bias because we are in an 8-year long bull market, remaining fully invested is the best choice for individual investors.
With that said, there are alternatives to holding cash that still allows for some dry powder if financial assets become more attractively priced.
Investors with a higher risk tolerance could invest in a margin account and hold leverage fixed at 1.0x. If the markets present compelling buying opportunities, the investor could purchase securities using a prudent amount of margin (say, 1.2x) and then repay the margin loan using future investment contributions.
For most investors, though, remaining fully invested and implementing dollar cost averaging through regular portfolio contributions is likely the best path to building long-term wealth.
Owning Too Much Fixed Income
Fixed income securities – government bonds, corporate bonds, and certificates of deposit – are sought by investors not for their total return potential, but for their capital preservation capabilities and low volatility.
Fixed income instruments are especially useful for retirees. Regular (usually semiannual) bond coupons payments have the potential to cover a retiree’s living expenses if the market value of the investment portfolio becomes large enough.
However, the lower returns of fixed income securities can be a drag on portfolio returns (though to a lesser extent than cash) if a large allocation to this asset class is made.
This is particularly true for investors in the accumulation stage of their investing career.
During the accumulation stage, investors should be mostly concerned with maintaining a high savings rate and achieving satisfactory total returns in their portfolio. The proportion of total returns that comes from coupons/dividends versus capital appreciation is largely irrelevant since accumulation stage investors are focused on building their nest egg – not generating income from it.
To illustrate the affect of fixed income on portfolio performance, the following diagram compares the time-weighted total returns of fixed income investments versus dividend stocks over various time horizons.
The lower returns of fixed income instruments can also be seen in mixed portfolios, which are more realistic since most investors will hold some bonds and some equities (rather than all bonds or all equities).
To that end, the following diagram compares the time-weighted return of various fixed income allocations in a primarily dividend stock portfolio.
Two observations should be noted from the above diagram.
The first is that bonds are still a drag on total returns, even though bonds have outperformed cash and T-Bills.
The second is that the different time-weighted returns became much closer as more fixed income allocation was added to the portfolio. This is because bond returns have less volatility than equity returns, which means that annualized returns are expected to be much closer across different time periods than in equity investments.
So, bonds are a drag on performance for a portfolio that is invested primarily in dividend stocks. Where can investors find safe income that is diversified away from traditional common stocks?
Preferred stocks are a fantastic alternative – they offer high income and superior risk-adjusted returns when compared to traditional fixed income securities or dividend stocks.
Many preferred stocks yield above 5% right now. With that said, they will still have lower total returns than traditional equities over long periods of time, so investing in commons stocks is still the best option for total return investors.
Dividend stocks tend to outperform non-dividend stocks, particularly during market downturns.
This is because periodic cash dividend payments allow investors to continue buying stocks (beyond their regular contributions) when prices become more attractive.
From a qualitative perspective, there are additional reasons why dividend-paying stocks tend to outperform when the markets drop.
Dividend paying stocks are often stable, mature, blue-chip businesses that have operated for decades and benefit from a durable competitive advantage. Financial market participants understand that these companies are likely to endure all but the worst economic downturns, so their stock prices have smaller maximum drawdowns as a result.
With all this in mind, it might be tempting to pursue high yield dividend stocks in anticipation of the next recession. If dividend stocks outperform during recessions, then high dividend stocks must really outperform during recessions, right?
Unfortunately, this is not necessarily the case.
While high yield stocks deliver more income, they are also riskier. More dividend income means less retained earnings (all else being equal), which means that the company has a smaller internal margin of error if operations do not proceed as planned.
High yield companies often have debt. If earnings decrease meaningfully, there might not be enough cash to fund the company’s current liabilities due, which means the dividend will be cut to make up the difference.
Dividend cuts are a very bad sign for investors and trigger an automatic sell using The 8 Rules of Dividend Investing. This is because historically, dividend cutters have delivered atrocious total returns for their investors.
Source: Hartford Funds
Looking at the above table, we see that dividend growers have delivered the best returns over long periods of time, while simultaneously having the lowest beta.
High returns and low beta lead to a high Sharpe ratio – the most common metric used to calculate risk-adjusted returns. Beta is very important because it is the best metric to predict portfolio losses during a recession.
This encourages investors to find and invest in dividend growers and initiators. How do we find dividend growers?
Intuitively, companies with very long histories of growing their dividends are likely to continue doing so for the foreseeable future. Investors can look to companies with long streaks of steadily increasing dividends to take advantage of this market anomaly.
To that end, the following databases of stocks are great places to find companies with a high probability of increasing their dividends into the foreseeable future:
- Dividend Achievers: 10+ years of consecutive dividend increases
- Dividend Aristocrats: 25+ years of consecutive dividend increases
- Dividend Kings: 50+ year of consecutive dividend increases
Thus, investing in the riskiest high yield companies is a poor method to prepare for the next recession. Stable dividend growers (like the Dividend Aristocrats) are a better way to position a portfolio defensively. With that said, high quality established high dividend stocks can make sense for investors in need of current income – but one must be especially careful with what high dividend stocks to select.
With so much buzz about the next recession, it is tempting to spend a lot of time and energy thinking about and preparing for another inevitable economic decline.
However, there is an element of futility to defensive portfolio positioning. We have no real, material knowledge about the next recession – investors have no ideas when it will occur, how long it will last, or how severe it will be.
The only piece of information we do have is that there will be another recession – it is not a matter of if, but when.
Luckily, this article was designed to provide helpful investing information that is useful under all circumstances. Regardless of current economic conditions, the warnings in this article (don’t hold too much cash, minimize your allocation to fixed income, and avoid chasing yield) will help to reduce risk and improve investment returns.
For investors looking for information about how to properly position their investment portfolios for the next recession, the following Sure Dividend articles might be useful: