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Defensive Investments To Weather A Stock Market Correction

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First of all, I am not a financial advisor and I have no idea what the stock market is going to do next. I’m just trying to play defense on my IRA and you need to do your own research before making big changes to your investment. The reason why I’m writing this article is because I need to research and figure out what to do. Hopefully, I can get some suggestions from more experienced investors as well.

Last November, I rolled over my 401(k) to an IRA and invested everything in the stock market. This was a bit risky because my bond allocation went way down. Luckily, the stock market did very well and my IRA is up over 10% since I rolled it over. I’m very happy with that gain and I feel like that’s enough for 2013. I sold off most of the equities in the IRA and now I’m looking for a safe place to stash the cash while waiting for the opportunity to get back in again.

My goal for the rest of 2013 is 1-2% gain. I have been doing some research and it’s kind of tricky because there are risks and tradeoffs with any investments. Let’s take a look at some defensive investments that should be able to weather a stock market correction (a 10% decline.)

defensive investment to weather stock market correction

Money Market Funds

Since this is my IRA, I can’t just put it into a high yield saving account. The interest rate is very low at around 1%, but I would be happy with that. In the past, a good alternative to a saving account is the money market funds. Money market funds aim to earn interest for share holders while holding the value of your dollar. These days, the yields are rock bottom at around 0.01%. It’s basically the same as holding cash and I would like a little more return than that.

Bond funds

When you buy bond, you are lending money to an entity and receive interest payment. I plan to get back into the stock market later this year or early 2014 so I can’t buy bonds and hold them until maturity. Bond funds are a good option though. They will give a little higher return than money market funds. However, we all know the government will raise the interest rate at some point. This will impact bond funds and cause the price to go down. That’s why I have been reluctant to invest in bond. From what I understand, short term bonds will be least affected so that’s what I will concentrate on.

Treasury Bond

The Vanguard Short-Term Government Bond ETF (VGSH) yield 0.13% and the expense ratio is 0.12%. This looks like a mediocre choice to me. At best, we would collect 0.01% and if the interest rate rises, I’m sure the fund will drop more than that.

Corporate Bond

The Vanguard Short-Term Corporate Bond ETF (VCSH) yield 0.82% and its expense ratio is 0.12%. This is a bit better than Treasury bond, but it is also a bit more risky. I’m not sure what will happen to the bond price if we have a big stock market correction. It will probably hold up fine unless a bunch of blue chip companies go out of business and can’t pay back these loans. It would take a major meltdown to do that though and I don’t think that’s going to happen anytime soon.

High Yield (Junk Bond)

Junk bond has better yield than high grade corporate bond because the risk of default is much higher. I have never invested in junk bond before so I will need to proceed cautiously. Fidelity High Income (SPHIX) yield 5.32% and cost 0.76%. This sounds quite attractive actually, but I’ll probably invest a very small percentage of my portfolio here since I don’t have experience in this area.

Municipal Bond

Municipal bonds are tax free so generally it’s not placed in a tax deferred IRA. From what I read, the yields have fallen and interest rate risk has risen. Now is probably not the right time to buy municipal bonds.

GNMA

Vanguard GNMA Fund Admiral Shares (VFIJX) specializes in government mortgage-backed securities. GNMA securities are backed by the U.S. government and typically offer a higher yield than Treasury bonds. VFIJX yields 2.65% and the expense ratio is 0.11%. When mortgage refinance activity is high, the yield is likely to decrease because the mortgage loans aren’t carried out to maturity.

Defensive Stocks

Another way to weather a stock market correction is to invest in defensive stocks. Defensive stocks generally weather a down market better than other stocks, but don’t perform as well during a bull market. These days we can easily shift into defensive sectors through Vanguard ETFs. Utilities (VPU), healthcare (VHT), and consumer staples (VDC) are doing quite well lately. Investors need to know that this is much riskier than investing in bonds.

Play Defense

I feel the stock market ran up quite a bit this year and it’s probably due for a correction at some point. The stock market also has been very volatile lately and my IRA is happy to sit it out for a while until it settles down. When I was working, I generally just ignore the stock market swing because I can keep averaging in during a down market. Now that I can’t add as much money, I will need to limit my losses more by investing defensively.

After looking over this list, I think I’ll go with short term corporate bond and GNMA for the most part. I’ll invest a small portion in high yield so I can see what it’s like. I would love to hear some advice from investors with more experience. What would you invest in when your main goal is to preserve capital in the short term? Did I miss anything? Gold?

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{ 20 comments… add one }
  • My Financial Independence Journey April 26, 2013, 2:33 am

    I must have missed something. It’s not clear to me why you’re worried about the short term in an IRA. Assuming that you’re 40, you’ve got another 19 years to wait before you can access that money. I would invest in a regular old stock market index fund. Or if you’re willing to hunt around, dividend growth stocks in generally defensive industries.

    • Dividend Growth Investor April 26, 2013, 9:56 am

      Ouch, I think you are making mistakes, and then you are working to “compound them”.

      I don’t think that selling stocks was/is a wise idea. Small investors usually perform badly because they try to time the market – and they are not good at it. True, stocks can fall by 20% from here. If you had your dividend paying stocks, you should have been just fine – receiving dividends one check at a time.

      Now you want to purchase bond funds, which can go up or down in value depending on a variety of factors such as interest rates, inflation, economic output, etc etc. All for a pursuit of 1%. These funds fluctuate in value and while you can get some yield, they can still decline by more than the yield amount for the timeframe you are using.

      If I had cash now, I would invest it. Either all at once, or using equal amounts over the next 6 – 12 months. I could also sell slightly out of the money cash secured puts expiring in 1 – 2 months. Or I could simply wait in cash.

    • Steve April 26, 2013, 11:39 am

      I agree. I would not face this question because I don’t harbor the illusion that I know where the stock market is going in the near term.

      But to answer the question, if I wanted to preserve capital, sounds like your only choice is a money market account. All the other options you listed are NOT guaranteed against loss of principal. There are other safe vehicles, but none that are accessible from inside an IRA as far as I know.

      • retirebyforty April 26, 2013, 10:20 pm

        Thanks for the advice. In the past I always ride out the downturn by investing more. I’ll keep your comments in mind, but I think sometime you just have to make some mistakes to learn.
        Keeping the money in money market fund is a good option and that’s where it is now.

  • so April 26, 2013, 12:19 pm

    This is a bad idea. If you have enough of a cash buffer, keep the money invested, you are already playing sufficient defense. People thought like this in the last four years and wound up missing big chunks of the recovery.

  • Pretired Nick April 26, 2013, 1:38 pm

    I also, have felt like a correction is on the way. However, I keep repeating to myself “don’t try to time the market”. I agree with the comment above that focusing on dividends is probably the best way to keep your heart rate down.

  • SavvyFinancialLatina April 26, 2013, 1:48 pm

    Great informational article! I will favorite it, so I can reference. I am starting to look more into investing.
    I am really interesting in adding VPU to my ROTH IRA, but found out I have to open a brokerage account with Vanguard before I can buy index funds.

    • retirebyforty April 26, 2013, 10:21 pm

      You should be able to buy VPU from almost any brokerage. Check with your broker to see if you can buy VPU. You don’t have to have an account with Vanguard.

  • Travis April 26, 2013, 5:59 pm

    I’ve been using VFIJX as my savings account. The return has slowly been going down each year as more people have been refinancing, but it’s still at least 2x better than any high yield savings account I’ve found.

  • Joey April 26, 2013, 7:46 pm

    At your age, I would be investing in stocks now. You have time on your side. There has not been any time in history where stocks weren’t up 15 years later.

  • Mr. Bonner April 26, 2013, 10:30 pm

    I’ve been thinking along similar lines, but haven’t made any moves, yet. I probably won’t change any current investments, but I need to decide what to do with the cash we have. I’ve been thinking about P2P lending as an alternative to a questionable market. Or the guaranteed return of paying down our mortgage faster is always an option. Still thinking…

  • Mike April 27, 2013, 7:30 am

    I think you need to research more. I know I would. However, you have to consider what your goals are, and what you want to do to achieve them. Sometimes, you might need to reinvest into the mediums you are already investing in. Other times you might need to take some of those paybacks into “safer funds” like CDs or Bonds. It depends on where you want to go and the track that you are taking to get there.

  • Kris @ Everyday Tips April 27, 2013, 1:39 pm

    It’s funny because the behavior of the stock market since I got out of college in 1991 has not necessarily been in line with traditional expectations. (Or at least that is my perception.)

    The stock market is obviously doing well right now, which always makes me leery of a correction. However, I have left our retirement money alone for now. I just try to balance my portfolio periodically as I get older and our needs change.

    If I had a bucket of cash right now, I don’t know what I would do with it. Probably just wait it out a little while. It would be nice to have that bucket though!

  • A small percentage of junk bonds, I find, is often helpful in balancing losses in other areas. Great post.

  • LAPhil13 April 29, 2013, 6:36 am

    I could pile onto the need to get a comprehensive plan, not just a stock-broker/market timing type of approach. Plan for the long term. Also, you make a mistake in stating that a fund with a yield of X and an expense ratio of Y will end up yielding X-Y. Any stated yield or return on a fund is after the expenses have been taken out. It is a good idea to use low-cost funds, but too many people get locked onto that without understanding that the returns shown are what has been realized after expenses. And, of course, any stated yield is not a future guarantee – it’s what it is a/o the state period and can/will change.

  • Anton Ivanov | Dreams Cash True May 11, 2013, 8:01 pm

    Something to consider for Junk Bonds Funds – they are much more closely correlated to stock market performance than other bonds. If you are absolutely sure about the upcoming correction, they may not be such a great idea, since they will go down with the stocks, which may completely offset their higher yields.

    Another great save investment is TIPS funds, although those are pretty much as conservative (and low yield) as you can get.

  • Best dividend paying stocks May 14, 2013, 3:56 am

    I like your article. Investing in defensive stocks is also one of the best ways to be a successful stock market investor. You can determine the best defensive stocks by concentrating on companies that involved in those projects and systems that will be considered essential and unlikely to see reduced spending.

  • davidmichael July 3, 2013, 8:48 am

    Joe,
    In this April blog, I see that you are considering different funds. If anything, I would be overly conservative because the answer is in compounding.

    I lost a great deal of money twice (two market meltdowns) because I thought I could do better than the overall market by trading covered calls. Supposed to be a conservative investment, but when the market turns it can be deadly. Thus, I advise investors starting out to buy three Vanguard Index funds (Total Stock Market, Bond Market, and International), and hold them for 30 years or more.

    My easiest and most successful investment was I-Bonds with a 3% fixed rate plus Inflation which has amounted to a total of 5-6% annually. No risk and no worry which is worth a lot as one gets older.

    I like your idea of buying dividend stocks over a long period of time and evenutally living off the dividends in retirement. My lawyer and his partners are doing the same for their 401K. As a I mentioned previously, all of my traching buddies became multimillionaires through rental real estate, buying one house at a time. So, all in all, I think you are doing really well. Congratulations! Your online income blows me away. Amazing!

    • retirebyforty July 4, 2013, 12:47 am

      Thanks for your advice. Dividend stocks are doing well right now, but I think we still need index funds and bonds too. I’m afraid to put all my eggs in one basket now. Thanks!

  • Ernest Grolimund January 30, 2016, 8:38 am

    2016 presents the same situation only more worrysome. An Edward Jones chart of the DOW and the 18 year bul and bear business cycle was most helpful in deciding what to do for me as a non professional investor. The stock market crashed in 2009, the year it went into the bear cycle. Economist Davidson predicted it. Davidson also predicted the 2008 crash, I don’t know how far in advance. A top and bottom envelope is plain now and a pattern supports Davidsons prediction of another crash in 2015 when the Dow hits the high envelope and 2 small corrections have occurred in 15 and 16 when the Dow approached the high envelope. My wife and I were in money market funds for safety but wanted some return, so we invested in a futures fund which is like a day trading strategy following the futures value on CNBC. The futures predicts advances and declines and futures funds are in and out depending on the future estimates. They are not long term high fliers but appear to be good in downturns like 2008. In 2016, they are up in Jan when the Dow is down 12%. We also invested in HTUS, a market timer fund of funds. They are 96% cash with some futures trading. And they are up a little while the DOW is down 12%. We wanted to get into a bear fund but found a load on it through Fidelity which turned us off. Bear Funds do well in bear markets but lose a little in bull markets. But you have to know when a crash is likely and it definitely is a bet or speculation based on economists like Davidsons predictions. Another fund is municipal bond funds, up so far when the Dow is down. Fidelity estimates the interest rate hikes will be small and far in between this year so the bond funds is likely to return around 4% or 5%. So we invested in this but will watch it closely since the fund crashed in 2008 too. Any sign of an unexpected decline in the municipal bond fund and we are out. It sure is hard investing now and we are doing a lot for an estimated 5 to 10 % return. Make us wonder if the HTUS approach is best. IE, when you feel or suspect a crash is coming, get out for a year or so and get back in after a correctionto 9,000 or 10,000. Once the market enters the business bull cycle, traditional long term investing sounds good if you have a long time frame and do not have to protect a huge lifetime retirement account. But in an 18 year business cycle bear market, you usually do not make anything base on the line splitting the envelopes and the top envelope is rising at a paltry 3%. What causes the volatility? Businessmen appear to know when they are in up and down cycles and get corporate money in and out following the business cycle. The Edward Jones firm says it the best indicator of the DOW. Corporations at the moment are not investing in their own companies to make additional earnings. Sounds like they are deliberately manipulating the market driving it wildly up and down and politicians can’t figure out how to stop it. So, Caveat Emptor. There is no one good except those to whom the logos or spirit has come according to Jesus.

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