The shallow — but sharp — drawdown in financial markets over the past few weeks is a good reminder that equity indices do not always move “higher and to the right” the way we would like. In most environments, a 5.6% drawdown in the S&P 500 is not much to write about, but for a variety of reasons this particular pullback has attracted significant attention. Investor concern about elevated valuations, the direction of Federal Reserve policy, and the impact of new legislation are all contributing to a market that feels on edge. While it is generally wise to look through the noise of short‑term drawdowns and remain focused on the long term, incorporating thoughtful defensive strategies into your asset allocation can help you weather larger storms when they eventually become more severe.
In this post, we will examine several strategies individual investors can use to help protect their portfolios and highlight the potential advantages and drawbacks of each.
Holding Cash
Selling riskier assets, such as stocks, and moving into cash is one of the most straightforward and cost‑effective ways to reduce portfolio risk. Today, many money market funds yield in the 3.4% to just over 4% range, providing a modest, slightly above‑inflation return. By raising your cash allocation, you can quickly reduce volatility and expected drawdowns, while retaining flexibility to reinvest at more attractive entry points.
The challenge with this approach is timing and sizing. Expecting a drawdown that never materializes can cost you upside, and maintaining elevated cash balances over long periods can become a meaningful drag on long‑term returns. In addition, although higher cash holdings reduce downside risk, cash returns are unlikely to fully offset negative returns from the equity portion of your portfolio during a meaningful sell‑off.
Intermediate to Long‑Duration Bonds
An alternative to holding only cash and money markets is to extend the maturity profile of your fixed income into intermediate (roughly 3–10 years) and long‑duration bonds (10+ years). In a normal, upward‑sloping yield curve, shorter‑term bonds typically yield less than longer‑term issues, so investors are compensated with additional yield for extending maturity. More importantly, intermediate and long‑duration bonds carry greater interest rate sensitivity (duration), meaning their prices respond more to changes in market interest rates. Higher duration generally translates into greater price appreciation when interest rates fall.
In a risk‑off environment, when investors sell risk assets and seek safety, demand for U.S. Treasuries often pushes interest rates lower and bond prices higher. In those periods, the total return from intermediate and long‑maturity bonds — coupon income plus price appreciation — can help offset steep equity declines and provide additional downside protection.
This strategy, however, comes with tradeoffs. The same duration that helps when rates fall can be painful when rates rise, as 2022 demonstrated when both bonds and equities sold off simultaneously, producing one of the worst years on record for traditional 60/40 allocations. Other considerations, such as credit risk and liquidity risk, also need to be evaluated before materially increasing exposure to longer‑duration fixed income.
Low Beta / Low Volatility Stocks
For investors who want to remain invested in equities while dialing down risk, one approach is to tilt toward lower‑beta, lower‑volatility stocks in more defensive sectors such as Consumer Staples, Healthcare, and Utilities (though utilities have recently traded more like growth stocks). These businesses tend to provide products and services that households and companies rely on regardless of the economic backdrop: food and beverages, household essentials, and critical healthcare.
Historically, these sectors lag high‑growth areas like technology when markets are strong, but they also tend to decline less when broad indices sell off. Allocating to lower‑beta stocks does not usually provide the same downside protection as high‑quality bonds, but it can reduce portfolio volatility and offer materially more upside than a pure shift into cash or fixed income in strong market environments.
Liquid Alternatives
Institutional investors — including pension funds, endowments, and foundations — often rely on a range of alternative strategies for diversification and downside protection, such as hedge funds, private credit, real estate, and real assets like energy and infrastructure. These vehicles are typically complex, illiquid, and available only to large or ultra‑high‑net‑worth investors.
In recent years, however, a growing number of mutual funds and ETFs have brought “liquid alternatives” to a broader base of individual investors. One of the primary benefits of these strategies is their historically low correlation to traditional stock and bond markets. Managed futures or trend‑following strategies, for example, can take both long and short positions across equities, fixed income, commodities, and currencies. By systematically or algorithmically adjusting their exposures, these funds seek to participate in both rising and falling markets by aligning with prevailing trends.
That said, liquid alternatives come with their own set of drawbacks: higher fees, shorter or untested track records, and less transparency regarding underlying positions and risk management. While some trend‑following strategies performed exceptionally well in 2022 when both bonds and stocks declined, longer‑term results are mixed, and they do not always deliver the level of downside protection investors may expect.
Options like Portfolio Insurance
Other strategies, such as using protective puts, function more like an insurance policy against declines in specific equity positions or broad indices. A “put” is a derivative contract that derives its value from an underlying security or index. For example, if an investor wants to hedge exposure to ETF SPY, which tracks the performance of the S&P 500, they can purchase a put option that allows them to sell a predetermined number of shares at a specific strike price on or before a certain expiration date.
Like other approaches, protective puts also have drawbacks. Options typically carry higher transaction costs and, in some structures, may involve counterparty risk if transacted in over‑the‑counter markets rather than on an exchange. The option premium required to implement a protective put strategy can be costly to maintain over time, especially if the feared drawdown does not materialize. However, much like other forms of insurance, these strategies can provide some of the most effective downside protection in periods of severe market stress. Options involve a high level of risk and are not suitable for all investors; any options‑based approach should be evaluated carefully considering an investor’s objectives, experience, and financial situation.
Diversification
“Diversification is the only free lunch in investing” may be overused, but the underlying concept still holds. Each of the strategies discussed above has strengths and weaknesses and tends to work better in certain market regimes than others. By thoughtfully combining multiple defensive tools — cash, varying durations of fixed income, defensive equities, select liquid alternatives, and, where appropriate, options‑based hedges — investors can build portfolios that are better aligned with their individual objectives and risk tolerances while balancing upside potential and downside protection.
If you would like to discuss your current asset allocation or how these strategies might fit into your broader financial plan, please reach out to Vindicta Investment Advisors. We would be glad to review your situation and explore options tailored to your goals.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own situation before making any investment decision.