Defensive Asset Allocation – What You Need to Know

Although investing is often described as a balance between risk and reward, most investors care more about one than the other. When the stock market is soaring, we chase returns. When it crashes, we wish we had been more cautious. 

This emotional tug-of-war is why asset allocation is important. It determines how your investments are spread across different asset classes like stocks, bonds, and commodities, ultimately influencing your portfolio’s risk and return. Contrary to what you may hear from investing pundits and prognosticators, markets are unpredictable. 

That’s why Defensive Asset Allocation (DAA) can be a useful investment strategy – it is designed to help investors manage risk, protect against downturns, and still participate in market growth. This approach blends momentum investing and risk management to adjust allocations dynamically, aiming for steady long-term gains while avoiding catastrophic losses.

DAA differs from traditional asset allocation strategies by being proactive rather than reactive. Many investors follow a fixed allocation strategy, meaning they hold onto their investments regardless of market conditions. DAA, however, continually evaluates market trends and adjusts accordingly. If you define market timing as trying to predict when the markets will rise or fall, then we feel that nobody can consistently time the markets. But appropriately responding to events is something we all can do. DAA doesn't predict crashes—it responds to them as quickly as possible.

Investing is never about avoiding risk entirely—it’s about managing it wisely. A well-structured portfolio should not only capitalize on growth opportunities, but it should also shield against significant losses. The financial landscape is littered with investors who suffered severe setbacks because they failed to adjust to changing conditions. Defensive Asset Allocation provides an alternative, allowing investors to stay engaged with the market while mitigating excessive downside risk. This strategy is particularly valuable during times of economic uncertainty when traditional investment approaches may struggle to adapt quickly enough.

By the end of this guide, you’ll understand what Defensive Asset Allocation is, how it works, its pros and cons, and whether it suits your investment goals.

What is Defensive Asset Allocation?

Defensive Asset Allocation (DAA) was developed by Wouter Keller and JW Keuning as an investment strategy that reacts to market trends rather than predicting them. Unlike traditional buy-and-hold methods, DAA actively adjusts a portfolio based on market conditions, focusing on capital preservation and steady returns.

Core Principles of DAA

1. Momentum-Based Investing – DAA prioritizes assets with strong recent performance, a principle rooted in behavioral finance: assets that have been rising tend to continue rising, and vice versa. By identifying these trends early, DAA captures upside potential while systematically cutting exposure to declining assets. This ensures that capital is allocated efficiently, reducing the chances of being stuck in prolonged downtrends. Momentum is one of the few verified anomalies in the markets.
2. Breadth Momentum – This concept tracks the overall market’s strength. If only a few assets are performing well while the rest lag, it signals potential trouble ahead. Breadth momentum provides insight into whether a rally is broad-based or driven by a handful of stocks. If market participation weakens, the strategy shifts toward defensive positions, helping investors avoid market corrections before they fully unfold. This principle is important for spotting early warning signs of downturns and preventing significant portfolio losses.
3. Defensive Shifts – When market conditions weaken, DAA reallocates into safer investments like government bonds, cash, or defensive assets to mitigate risk. Unlike traditional strategies that stay fully invested in equities regardless of volatility, DAA proactively moves capital away from riskier positions when warning signals emerge. This ability to switch between risk-on and risk-off modes helps smooth returns and reduces drawdowns so that investors are not caught off guard by sudden market downturns.
4. Adaptive Rebalancing – Unlike traditional rebalancing methods that follow a fixed schedule, DAA employs adaptive rebalancing based on market conditions. This means it adjusts allocations dynamically rather than waiting for a pre-set date. When the market exhibits strength, DAA increases exposure to high-momentum assets. When risk indicators rise, it moves swiftly into defensive positions. This approach provides a continuous, responsive framework that enhances portfolio resilience. Adaptive rebalancing not only maximizes participation in bullish trends but also acts as an insurance mechanism against prolonged downturns, making it a key differentiator of DAA from static asset allocation models

The goal is simple: protect against downturns while maintaining steady growth.

Why Traditional Strategies Can Fall Short

Most investors are familiar with buy-and-hold or the 60/40 portfolio, where 60% of investments are in equities and 40% in bonds. While these approaches have worked historically, they are not immune to severe drawdowns. In 2008 and 2020, markets crashed rapidly, and many investors saw years of gains wiped out in months.

DAA offers an alternative by making tactical asset allocation decisions. If market signals turn negative, the strategy moves towards defensive investments to avoid deep losses.

Key Components of Defensive Asset Allocation

1. Asset Allocation Breakdown

A typical DAA portfolio consists of:

• 43% Equities (stocks, ETFs, and exchange-traded funds covering broad markets)
• 40% Bonds (government and investment-grade bonds)
• 17% Alternative Assets (real estate investment trusts, gold, commodities)

This diversification ensures exposure to growth while maintaining downside protection. A well-balanced portfolio mitigates risk by spreading investments across various asset classes, reducing the impact of volatility in any single market. This allocation is also flexible - adjustments are made based on market conditions to optimize performance. The combination of equities for growth, bonds for stability, and alternative assets for hedging enhances resilience in different economic environments.

This diversification ensures exposure to growth while maintaining downside protection. A well-balanced portfolio mitigates risk by spreading investments across various asset classes, reducing the impact of volatility in any single market. This allocation is also flexible - adjustments are made based on market conditions to optimize performance. The combination of equities for growth, bonds for stability, and alternative assets for hedging enhances resilience in different economic environments.

2. Momentum Investing

Markets are constantly shifting, and DAA allows your portfolio to remain on the right side of momentum. Instead of blindly holding assets, it allocates more to the strongest-performing investments and reduces exposure to those losing momentum.  Momentum investing captures trends effectively by systematically favoring assets that demonstrate upward price strength. By leveraging recent price movements, DAA prevents investors from holding onto underperforming positions, thus reducing downside risk. This method also minimizes emotional decision-making, allowing for a disciplined, data-driven investment approach that adjusts dynamically to market trends.

Many times, momentum investing has outperformed static allocation strategies because it avoids prolonged downturns in weak asset classes.

3. Breadth Momentum & the Canary Universe

DAA uses a "canary universe"—a small group of highly sensitive assets—to signal market stress. If these assets start underperforming, the strategy proactively moves into defensive positions. This helps avoid large drawdowns that traditional investors often endure.  The canary universe acts as an early warning system, identifying signs of weakness before they escalate into full-fledged market downturns. By tracking a diverse selection of risk-sensitive assets, DAA ensures that investors have ample time to reposition their portfolios and mitigate losses before broader market conditions deteriorate significantly.

4. Risk-Adjusted Position Sizing

One of the most important but often overlooked components of DAA is risk-adjusted position sizing. Rather than allocating an equal percentage to each asset class, DAA dynamically adjusts position sizes based on risk levels. Higher-risk assets receive smaller allocations, while lower-risk assets receive larger allocations, allowing the portfolio to remain balanced in various market conditions. This principle enhances stability and reduces exposure to high-volatility investments, helping to maintain consistent returns. By continuously adjusting position sizes in response to market changes, DAA prevents excessive concentration in any one asset, thereby reducing portfolio-wide risk.

How Does Defensive Asset Allocation Work?

The strategy follows a structured decision-making process:

1. Identify Risky vs. Defensive Assets

• Risky assets: Equities, high-yield bonds, and emerging market stocks
• Defensive assets: Government bonds, cash, and defensive investments

2. Allocate Based on Performance

• The best-performing assets receive higher allocations
• If market signals turn negative, the portfolio shifts to safer holdings

3. Monthly Rebalancing

• Unlike traditional portfolios that rebalance quarterly or annually, DAA adjusts monthly to respond quickly to changing market conditions. It should be noted that this is just a guideline. There may be times where more frequent rebalancing is warranted. There could also be times when longer term rebalancing is more appropriate.

By staying adaptive and systematic, DAA avoids panic-driven decisions while ensuring steady investment returns. Investment decisions made in a panic and emotionally driven state tend to be some of our worse mistakes. 

Benefits of Defensive Asset Allocation

1. Risk Management – By reducing exposure to declining markets, DAA helps protect investors from large drawdowns.
2. Steady Performance – While performance is no guarantee of future results, historical performance shows that DAA smooths out returns and minimizes volatility. Let the math work for you, so you do not spend as much time making money that you have already made one before.
3. Diversification – Exposure to a broad mix of asset classes helps reduce concentrated risk.
4. Behavioral Discipline - One of the often-overlooked benefits of DAA is its ability to enforce discipline by removing emotional decision-making from investing. Many investors react emotionally to market swings, often buying high and selling low. DAA’s systematic approach promises that portfolio adjustments are made based on predefined rules and data rather than fear or greed. This helps investors stay invested and make rational, data-driven choices rather than succumbing to panic.
5. Reduced Sequence Risk for Retirees - Retirees drawing from their portfolios are particularly vulnerable to sequence-of-returns risk, where withdrawing funds during a market downturn can deplete assets faster. DAA helps reduce this risk by shifting allocations away from equities during market downturns and into safer asset classes like government bonds and defensive assets. This results in a more stable withdrawal strategy, helping retirees preserve capital for longer periods and reducing the likelihood of running out of money too soon.

Additionally, DAA reduces emotional investing. Many investors panic and sell during downturns, locking in losses. DAA follows rules-based rebalancing, eliminating guesswork.

Potential Drawbacks of Defensive Asset Allocation

1. Limited Upside in Bull Markets – When markets surge, DAA may lag behind fully invested portfolios. This was more evident in the bull market from 2009 to 2020, and the periods after Covid when the Nasdaq 100 and the so called “Magnificent 7” stocks led the markets.
2. Frequent Taxable Events – Monthly adjustments can result in short-term capital gains, making the strategy less tax-efficient. This strategy will be best suited for tax-deferred accounts such as IRA’s.
3. Dependence on the Canary Universe – If the selected "canary" assets fail to predict downturns, the strategy could miss key market signals. You need to be comfortable with the fact that there will be many times you will be wrong about the direction of the markets.
4. Higher Maintenance – Implementing this strategy does require more regular attention than more traditional approaches. You must be willing to put it the time and effort otherwise, your results could be far worse than implementing a much simpler Buy and Hold strategy.

Who Should Consider Defensive Asset Allocation?

• Investors Seeking a Balance Between Growth and Protection – If you want exposure to equities but also want safeguards in place, DAA provides a structured way to mitigate risks while still benefiting from market upswings.
• Moderate Risk Tolerance Investors – Those who are comfortable with some market fluctuations but prefer to limit extreme losses can benefit from DAA’s ability to shift into defensive assets when necessary.
• Investors Focused on Minimizing Drawdowns – If your priority is to protect capital during bear markets, DAA helps avoid prolonged downturns by proactively reallocating to safer assets.
• Retirees and Pre-Retirees – Those nearing or in retirement benefit from reducing sequence-of-returns risk, ensuring they do not withdraw funds from a declining portfolio.
• Investors in Tax-Advantaged Accounts – Since DAA involves frequent rebalancing, using tax-advantaged accounts like IRAs or 401(k)s helps minimize tax consequences.
• Investors Looking for a Rule-Based, Emotion-Free Strategy – DAA follows systematic, data-driven rules, removing the emotional biases that often lead to poor investment decisions.
• Long-Term Investors Seeking Stability – If you prefer a smoother return profile over time rather than extreme market highs and lows, DAA can help manage portfolio volatility effectively

Defensive Asset Allocation vs. Traditional Strategies

Conclusion: Building a Resilient Portfolio

Defensive Asset Allocation provides a structured way to navigate market uncertainty, blending momentum investing and tactical asset allocation to adjust as conditions change.

No strategy is perfect, and investment returns will always vary, but if your goal is to protect capital while still participating in market growth, DAA is worth considering.

Would it be the right addition to your portfolio? That depends on your risk tolerance, financial goals, and patience for periodic adjustments. If staying adaptable appeals to you more than riding out the next crash, then DAA might be the missing piece in your investment strategy.

Remember, investing is personal. What worked for your neighbor or coworker does not mean it is right for you.  Before making any changes, preparation and approaching it with realistic expectations is the key. After interviewing and consulting with thousands of investors over the last 25 years, we have found they all eventually fall into the same trap - their investments did not match their expectations, causing an emotional reaction when this occurs. We will present you with a fuller, more reliable expectation picture of your investments.  This allows you to confidently navigate down whatever investing path you decide. 

Spend a few minutes with us to see if we are a good fit for each other.