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How to Invest Defensively: Part 1

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“Rule number one: Never lose money. Rule number two: Never forget rule number one.” Superinvestor Warren Buffett lives by that advice, and it seems to have worked out well for him. Investing defensively, as Buffett does, is easier said than done, but the right strategies can certainly help you avoid losing money. In the first part of this series, I’ll focus on one of the most important metrics you can use to find defensive stocks: beta.

In layman terms, beta measures how volatile a given stock is compared to the overall market. For example, when the benchmark index rises by 1%, does the stock also rise by that much? By more? By less? Or does it fall when the index rises? Calculating beta involves more complex econometrics and mathematic formula, but that simple explanation gives you the gist of it. You can easily find a stock’s beta listed with its other key statistics on any stock pricing platform.

Once you know a stock’s beta, you need to learn how to interpret it – a two-part process. First, we need to look at “systemic risk”: How risky or unstable is the market as a whole? When the whole market is suffering from a global financial crisis like 2008, even the most diversified portfolio can’t save you from losing value. If a stock has a beta of 1, then, in theory, its stock price is completely correlated to the market. When the market drops by 1%, the stock drops by the same. The closer a stock’s beta is to 1, the more likely its risk will match that of the overall market.

Second, we need to examine “unsystemic risk,” the risk associated with the individual stock. Stocks with betas greater than 1 are more volatile, for good or ill, than the market; a stock with a beta of 2 is twice as volatile as the overall market, meaning it generally rises twice as high or falls twice as far as the market does. And stocks with negative betas move opposite to the market; if the index falls, these negative-beta stocks tend to rise. Unlike stocks vulnerable to systemic risks, you can lessen the potential perils of stocks like these by making them part of a diversified portfolio, which can smooth out their peaks and valleys.

Perhaps you may be asking: Should I ONLY invest in stocks with negative beta to avoid losses during a financial crisis? Well, sure, if you’re a prophet, and know exactly when financial crises will strike. If you can’t see the future with perfect accuracy, probably not. After all, if the market as a whole is steadily rising, negative beta stocks will likely fall – and as we noted above, the whole point of defensive investing is not to lose money.

Low beta stocks make a great tool to diversify your portfolio’s risks. Just remember that financial markets are prone to large, unavoidable surprises like political issues, and a high, low, or negative beta can’t always predict how a stock will behave.

In the next part of this series, we’ll talk about which sectors of the market generally offer the best defensive opportunities, and how to look for the right companies within those sectors. Stay tuned and stay Foolish!

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