An Arsenal for the Defensive Investor

Here are 10 ways you can shield your portfolio from more market damage—and maybe even fight back a little

By Ricky McRoskey

Investors' assets are under siege.

Since the start of the year, companies in the broad stock market benchmark S&P 500 index have lost nearly $2 trillion in market value, the blue-chip Dow Jones industrial average has flitted in and out of bear territory, down nearly 20% from its October 2007 high, and the corporate bond default rate has more than doubled. To boot, U.S. home prices have dropped more than 16% over the past year in the country's 10 largest cities, according to the S&P/Case-Shiller Home Price Index for May. It's been a gut-wrenching experience for investors watching retirement savings and future college tuitions get hammered.

Some pros caution against any substantial moves after a market rout has already happened. But investors can still dodge the recessionary blows—or even start fighting back. For those who can't stomach the thought of additional losses, switching to cash or U.S. Treasuries is never a bad option; over the last 10 years, a savings account yielding 2% has returned more than the S&P 500 Index. And for resilient investors with slightly more appetite for risk, putting money in funds that take short positions against major stock indexes, or even buying certain types of corporate debt, can still limit downside while spurring returns.

How can investors play defense? In the grand scheme of things, the No. 1 strategy should be diversification. But you should already be doing that, whether times are good or bad. Digging a little deeper into the defensive playbook, here we present a 10-level approach to defensive investing—an arsenal recommended by financial professionals, ranging from the iron-clad safety of cash to vehicles with slightly more risk but with a reasonable degree of safety, like bank bonds.

1. Cash

So it's not the most exciting choice, but for those too bedeviled by the market's recent unpredictability to dabble in stocks, investing in cash is a good defense. Banks offer money market accounts—essentially limited-withdrawal savings accounts that accrue interest—to attract deposits. They are insured by the FDIC for up to $100,000 and generally yield anywhere from 2% to 4% annually. Though less liquid, a certificate of deposit is a higher-yielding cash option. Considering that $1 invested in the S&P 500 in January 2000 is worth about 87¢ today, cash isn't necessarily a terrible refuge. "People always pooh-pooh cash," says Rich Bernstein, chief investment strategist at Merrill Lynch (MER). "But at least it's up."

2. U.S. Treasuries

Of course, U.S. Treasury bond returns aren't exactly sexy, but they are steady. As of July 29, 10-year Treasury notes yielded 4.04% for investors, while 30-year bonds stood at 4.62%. The problem with this investment is that, while returns are automatic, they won't necessarily beat inflation. For example, a two-year note today yields 2.62% per year. That's well behind the 5% annual overall inflation rate according to the June consumer price index (CPI). So while investors can sleep tight knowing that the "full faith and credit" of Uncle Sam is backing their investment, their purchasing power might be taking a hit. "If you bought a bond today with a 5% yield and inflation averaged 6% over the next 10 years," says Jonathan Bergman, chief investment officer at Palisades Hudson Asset Management in New York, "you'd have a terrible investment."

3. TIPS

That's why the Treasury offers bonds that factor in inflation. TIPS, or Treasury Inflation-Protected Securities, are fixed-rate bonds whose principal grows (or shrinks) at the same rate as inflation. Investors can purchase the notes in $100 multiples through the Treasury's official Web site. At the latest TIPS auction, a 20-year bond expiring in July 2028 yielded 2.21%. "TIPS might be a good place to start" for defensive-minded investors worried about rampant inflation, says Hank Hanau, president of New York financial adviser HFH Planning.