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  • Writer's pictureAkshay Nayak

Defensive Investing Decoded - I : Conceptual Framework

The defensive approach to investing is one that is relatively lesser known. It is one that is boring and generates little excitement compared to most other approaches to investing. An investor following the defensive approach would place their focus primarily on avoiding serious mistakes and losses. They also focus on reducing the number of decisions they need to make in effectively managing their portfolios. They therefore look to build a portfolio that can largely run on autopilot.

While this may not attract the attention of most investors, the approach actually works. And there is hard data to prove it. So over my next three posts I will be dissecting the defensive approach to investing in detail. Today I will cover the concepts and principles that form the framework of the defensive approach. Next I will show why the defensive approach is an ideal fit for most retail investors. Finally I will show how portfolios can be designed with an orientation to the defensive approach.

The foremost concept behind passive investing is the distinction between enterprising and defensive investors. Benjamin Graham, a pioneer of modern investing first made this distinction. Enterprising investors are those who focus on researching and selecting securities on their own. They choose this route because they are willing to devote the time and knowledge required for doing so. They therefore expect to beat the return offered by the market.

Defensive investors lack the time and knowledge required for research and selection. They aim to put their portfolios on autopilot beyond a certain point. They are happy to accept market returns. They hence focus more on basic principles like risk management and asset allocation.

The level of time and knowledge required for successful enterprising investing is similar to that of a professional investor (for instance mutual fund managers, portfolio managers and so on). Most of us lack the ability or willingness to put in that kind of effort. It has been proven by hard research data that most enterprising investors fail to beat the market. Therefore the majority of us are better off being defensive investors.

The Random Walk theory is another key contributor to the passive approach. It states that the current market price of a security is the best forecast of its future price. This means past trends in price movements cannot be used to draw an inference on future price movements. Future price movements are likely to take a random and unpredictable path. This is similar to the steps of a drunkard. And therefore the name Random Walk theory.

Given that future price movements of securities are not predictable, it would be unwise to try predicting and profiting from them. Most investors should therefore follow the defensive approach to investing.

The concept of efficient markets also lends itself to the passive approach of investing. The concept is born from the Efficient Market Hypothesis (EMH). The EMH states that all available information about a stock is automatically factored into its market price. It therefore postulates that there is no scope for investors to beat the market if markets are fully efficient.

The veracity of the notion of fully efficient markets is always fiercely debated. But it is widely accepted that most markets are efficient most of the time. Indian markets are a lot more efficient than they were 2-3 decades ago. Indian investors would therefore be better off behaving as if markets are fully efficient. And the best way for investors to operate in fully efficient markets is to follow the defensive approach and consistently earn the average market return.

Another important explanation in favour of passive investing is a concept known as The Arithmetic Of Indexing. The concept focuses on the impact of investment costs on investment returns. It states that if investors were to pick stocks from a particular index, then before costs, their return will equal the return of the equivalent index fund. But the costs associated with active management are significantly higher relative to passive management. Therefore post cost, the returns on money invested in active management strategies would lag the return on money invested in defensive or passive products like index funds, for instance.

This shows that the observation that indexing works is not just a theoretical notion. It is a matter of mathematical fact. And the defensive approach to investing is centered around the use of low cost products like index funds. This again points towards the fact that the defensive approach would benefit most investors.

It is very well understood that building portfolios with negatively correlated assets lowers risk. But risk can also be lowered through adequate diversification within an asset class. Effective diversification within an asset class is achieved by holding a portfolio of securities that represents the broad market for that asset class. So the most viable way for investors to adequately diversify their portfolios would be to hold a broad market index fund at low costs. This would suffice the equity allocation in their portfolios. For the debt component a combination of EPF/PPF/SSY and low risk debt mutual funds (liquid and money market funds for instance) can be used.

There is hence enough conceptual and mathematical evidence to show that defensive investing works. Investors must understand these concepts and evidence clearly. It would help them appreciate the essential benefits of defensive investing. It is only after fully understanding these concepts that investors must adopt the defensive approach. In next week's post, I will discuss in greater detail the reasons why most retail investors would benefit from adopting the defensive approach.

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