Diversified Portfolios | March 22, 2022

Defensive Assets Play an Important Role in a Winning Strategy

When financial markets become turbulent it can be challenging to stay disciplined and focused on your long-term investment goals. These are the periods when investors sometimes let their emotions get the best of them and abandon their plans—potentially locking in short-term market losses. Times of turbulence underscore why it's so important to stick to time-tested investment principles like setting clearly defined goals as part of a long-term financial plan, investing in a diversified portfolio and ignoring short-term market noise.

While market turbulence can cause some anxiety, it's important to remember that these types of rocky periods inevitably occur from time to time. Investing in a well-diversified portfolio as part of a strategic asset allocation plan can help prepare you to withstand the inevitable periods of turbulence. Sticking with your long-term plan and avoiding the temptation to sell in a panic is one of the most important disciplines for successful long-term investing.

Schwab Intelligent Portfolios® is built on this foundation of asset allocation and diversification, with up to 20 asset classes in your portfolio. Defensive asset classes such as cash, gold and Treasury bonds play an important role, providing benefits of diversification that can help you weather these inevitable periods of market volatility.

Defensive asset classes have helped offset stock market declines

This understanding that markets can be volatile at times is why Schwab Intelligent Portfolios includes allocations to defensive asset classes as part of broadly diversified portfolios. Investors who hold defensive asset classes in their portfolios likely saw those investments play their important role of providing diversification and ballast to help offset stock market declines during the market tumble in Q1 2020 with the onset of the pandemic as well as during the more recent volatility in Q1 2022 with escalating geopolitical risks over the Russia-Ukraine conflict, elevated inflation and expected Fed rate hikes.

As Table 1 shows, U.S. large cap stocks were down 19.6% during Q1 2020 and 8.0% during the first two months of 2022. Other stock asset classes also fell, with U.S. small cap stocks down 30.6% in Q1 2020 and 8.7% during the first two months of 2022, while international stocks fell 22.8% in Q1 2020 and 6.5% so far in 2022.

Notably, however, not all asset classes declined over those periods of stock market volatility. Cash remained stable in both periods, providing its intended ballast. Gold rose 6.2% in Q1 2020 and 5.8% during the first two months of 2022. Treasuries rose 6.2% in Q1 2020, but rising interest rates presented a headwind during the first two months of 2022, resulting in a moderate decline of 2.0% and still helping to moderate overall portfolio declines relative to the major equity indexes.

Table 1: Defensive investments provided stability when stocks tumbled

Asset class Q1 2020 total return Jan-Feb 2022 total return
U.S. Large Cap Stocks -19.6% -8.0%
U.S. Small Cap Stocks -30.6% -8.7%
International Developed Market Stocks -22.8% -6.5%
Emerging Market Stocks -23.6% -4.8%
Cash 0.5% 0.1%
Gold and other Precious Metals 6.2% 5.8%
Treasuries 6.2% -2.0%

Source: Morningstar Direct, 1/1/2020–3/31/2020 and 1/1/2022–2/28/2022. Indexes used for each asset class are: U.S. Large Cap Stocks, S&P 500® Index; U.S. Small Cap Stocks, Russell 2000® Index; International Developed Market Stocks, MSCI EAFE Index; Emerging Market Stocks, MSCI EM Index; Cash, Bloomberg U.S. Treasury Bill 1-3 Month Index; Gold and Other Precious Metals, LBMA Gold Price; Treasuries, Bloomberg U.S. Treasury 3-7 Year Bond Index. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.

Defensive asset classes provide strong diversification relative to stocks

While cash, gold and Treasuries are all considered defensive asset classes, each arrives at that characteristic in a different way. Cash has historically provided stability in the form of very low volatility, along with a lower return. By contrast, gold has produced a high return along with high volatility. Treasuries are backed by the full faith and credit of the U.S. government, though they can be sensitive to changes in interest rates and have faced a headwind in the rising interest rate environment of 2022 compared with the environment of rapidly falling rates in Q1 2020. Importantly, what these asset classes share is a low to negative "correlation" with other asset classes such as stocks. This simply means that they tend not to move in lockstep with stock prices. When stock prices fall, they might remain stable or actually increase in value, as seen recently.

Correlation is a statistical measure ranging in value from +1 to -1. If two asset classes have a correlation of +1, that means they rise and fall together in perfect synchronicity. A correlation of -1 indicates that they move exactly opposite to one another. A zero correlation means that they move independent of one another. The lower the correlation, the greater the diversification benefit provided by investing across those asset classes.

As shown in Table 2, cash, Treasuries and gold have exhibited very low or negative correlation with stocks historically, providing strong diversification benefits. Because they don't move in lockstep with stocks, including these and other defensive asset classes in a portfolio can help moderate overall portfolio declines when stocks tumble.

Table 2: Defensive investments can provide important diversification relative to stocks

Asset class Correlation with U.S. Large Cap Stocks
U.S. Large Cap Stocks 1.00
U.S. Small Cap Stocks 0.88
International Developed Market Stocks 0.91
Emerging Market Stocks 0.77
Cash -0.27
Gold and Other Precious Metals -0.10
Treasuries -0.31

Source: Morningstar Direct, 3/1/2019–2/28/2022. Indexes used for each asset class are: U.S. Large Cap Stocks, S&P 500 Index; U.S. Small Cap Stocks, Russell 2000 Index; International Developed Market Stocks, MSCI EAFE Index; Emerging Market Stocks, MSCI EM Index; Cash, Bloomberg U.S. Treasury Bill 1-3 Month Index; Gold and Other Precious Metals, LBMA Gold Price; Treasuries, Bloomberg U.S. Treasury 3-7 Year Bond Index. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.

Defensive asset classes can help you weather periods of volatility

It's important to remember that periods of market volatility occur from time to time. A disciplined asset allocation plan that invests in a diversified portfolio across a broad range of asset classes, including defensive assets such as cash, Treasuries and gold, can help keep you focused on your longer-term objectives and avoid overreacting to short-term market volatility. Schwab Intelligent Portfolios is designed to provide broad diversification based on your financial goals and tolerance for risk.

Additionally, automated rebalancing within Schwab Intelligent Portfolios accounts helps investors stay on track with their strategic asset allocation plan, efficiently imposing a "buy low-sell high" discipline as markets fluctuate. This can be challenging during periods of market stress, so an automated rebalancing process can help take emotion out of the decision-making process. And automated tax-loss harvesting for accounts with $50,000 or more, allows investors to take advantage of market volatility by capturing losses that can be used to offset capital gains elsewhere in their portfolio, helping to reduce current tax liabilities and leave you more money to reinvest and potentially grow over time.

Sticking to a long-term strategic asset allocation plan through the inevitable periods of market volatility along with a disciplined process for rebalancing and tax-loss harvesting are key components for achieving long-term investment success.

David Koenig CFA®, FRM®, Vice President and Chief Investment Strategist for Schwab Intelligent Portfolios