When the Crowd Yells For Defense, What Would You Do?

The Oklahoma City Thunder recently lost a 15-point lead in Game 4 of the Western Conference Finals. What made this newsworthy was the fact that the Thunder’s 15-point lead was wiped out in five minutes.

No doubt the crowd screamed for better defense during those fateful five minutes. Noone could have predicted that a series of 2 to 3-point baskets by Dallas would have chipped away at the entire lead in such a short period of time. However, after the first 7 or 8 points I hope that the Thunder realized that it was completely possible and amped up their defensive strategy.

The same mentality applies to investing. If you’re invested in the market with a equity-based growth-oriented portfolio that is positioned to take advantage of a rising market, what happens if a key sector in your portfolio is exposed to an event that may impact earnings? Like a natural disaster? Or a war?

In life, we hedge against unplanned events with insurance.  If your portfolio’s stocks could talk, they may also beg for a defensive strategy to protect against unexpected events.  Especially if tide-turning events are imminent, including:

  • a transition into higher rates of deflation or inflation
  • a significant market downturn
  • a recession
  • a depression
  • stagflation
  • a significant rise in commodity prices

As with Game 4, once the losses start to happen it’s human nature to feel shell-shocked at first. So rather than attempt to make a decision in the midst of an event you never hoped would happen, ensure that a solid defensive strategy is in place prior to the event happening.

Looking at a basketball team, not every player is a forward. A solid team also has guards and a center who can either rebound or take a shot depending on the situation.

When constructing your portfolio, a similar strategy can apply. A percentage may be in small and mid cap stocks, emerging markets and growth-oriented sectors (often characterized by low to no dividends). Another percentage can be defensive against flat markets and downturns while still potentially able to provide growth in strong markets — for example, dividend-paying blue chips, large caps and developed market investing.

But what about “long-tail statistical events” — e.g., events that are statistically estimated to happen infrequently such as the 2007 Financial Crisis? Investment managers may plan for low-probability yet high impact events with derivatives (for example, buying puts or writing calls), with low or negative correlation portfolio construction, interest rate/currency/commodity/et al hedges, or even a strategy to get out of certain types of investments or sectors and hold cash if prices fall by 5-10%.

It’s very easy to buy a portfolio of investment, as is to put together a group of great individual basketball players. But a team with Michael Jordan and Karl Malone may not have done as well over the long term without Scottie Pippen and John Stockton. Be the coach of your portfolio, and ensure that you have strategies in place to withstand the unexpected so that you don’t end up sharing a beer with the Oklahoma City Thunder, wondering what just happened and what could have been.

 

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