What are defensive stocks? Stocks that provide stability to your portfolio regardless of whether the economy is up or down
- A defensive stock is a stock that provides consistent returns, regardless of how the stock market or economy is doing.
- Defensive stocks typically belong to well-established companies that offer goods and services people always need: household staples, utilities, and healthcare.
- Defensive stocks protect a portfolio from loss, but tend not to offer much growth potential.
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Most people invest for appreciation — to have their money grow. But growth isn't the only goal worth considering. A smart investment strategy also protects a portfolio, shielding it against financial downturns.
Defensive stocks function as their name suggests: They defend an investment portfolio against loss. While they don't offer huge growth potential, they perform consistently even during periods of economic decline, when other equities are tumbling.
Like a bulwark against erosion, defensive stocks can prevent your portfolio from substantially losing its value during a recession or bear market.
What is a defensive stock?
A defensive stock is a stock that can be relied on to provide consistent returns even during an economic or market downturn. Typically these companies offer goods or services that people continue to buy even when the economy isn't doing well.
There are no hard and fast rules to define a defensive stock, but there are some general guidelines you should look for:
- History of success: The company is established and very large in size. It has a couple of decades in business, at the very least, and a total market value in the billions is a reasonable threshold.
- Consistent dividends: The stock has consistently paid dividends over a long period of time — 10 years or longer.
- Low volatility: The beta coefficient, which measures a stock share's movements compared to the overall stock market's is low — ideally below one. This indicates that the stock isn't greatly affected by market swings. The beta coefficient is a complex economist's tool, but you can often find it in analyst's reports on a company, or it may be included in its online stock listing.
Conservative investors and investors who are investing to preserve capital often lean toward defensive stocks because of their reliability, while more aggressive investors may avoid defensive stocks altogether and protect their wealth by maintaining a buffer in cash and/or bonds.
However, a mix of both is usually wise. By developing an investment strategy that includes a healthy balance of both defensive and cyclical stocks in your portfolio, you're able to shield against total loss during a downtown and make the most of periods of economic growth.
Which industries have defensive stocks?
Defensive-stock companies are usually found in these fields or sectors:
- Utilities: Companies in the electric, water, gas, and waste management sectors offer necessary services, and continue to operate as usual through economic downturns.
- Consumer staples: When consumers are cutting their budgets down to bare-bones necessities, staples like household goods, toiletries, tobacco products, and food and beverages likely won't be eliminated. Within these, it can be smart to opt for companies that prioritize affordable brands.
- Healthcare: Healthcare is another good or service that consumers will continue to purchase in an uncertain economy, and for that reason, it's performed well over through recessions in the past. This sector includes insurance, pharmaceuticals, medical devices, and hospitals.
- Telecom: Telecommunications, which includes cable, phone, and internet service providers, are services that consumers never stop needing. They might cut back on or downgrade during hard times, but for the most part, these businesses' revenues stay pretty stable.
- Discount retailers: When the economy plummets, consumers pivot toward value. While most retailers tend to suffer during a recession, the ones that do well are those that help people get the best bang for their buck. These are companies that operate with large economies of scale and offer lower prices relative to their competitors.
These are the traditional defensive sectors. But it's possible for a company that's not necessarily in a "recession-proof" industry to still have stock that's considered defensive because of the company's size, history, and proven ability to adapt to changes in the market.
For example, some investors might argue that certain giants in the tech sector — like Amazon and Alphabet (Google's parent company) — are prosperous, life- and industry-dominant, and adaptable enough to be considered defensive stocks.
At the same time, just because a stock is in a defensive sector doesn't necessarily make it a defensive stock. It still has to meet some of the other guidelines mentioned above, such as consistently paying out dividends for a long period of time and having an established, sound financial track record.
Defensive vs. cyclical stocks
Defensive stocks are also sometimes referred to as non-cyclical stocks because they don't follow the cycles of the economy. In fact, they typically underperform when the market is up.
Cyclical stocks, on the other hand, are stocks that tend to do well when the economy is doing well. Think luxury goods and services. Of course, these are also the areas that people tend to decline during harsh economic times — the automotive, travel, and high-end retail industries are a few examples.
Some of the difference between the way defensive and cyclical stocks perform has to do with the industries they're in. Being in "recession-proof" industries such as utilities, healthcare, and consumer staples helps defensive stocks weather the ups and downs of the business cycle and makes them less volatile.
Cyclical stocks tend to be in industries that struggle during times of economic hardship — those that offer goods and services that people cut out of their budget when they're short on cash. In other words, they may offer more growth potential but with that comes more volatility.
Advantages of defensive stocks
- Stability: Market volatility can scare some consumers away from investing, and the stability of defensive stocks offers a solution to this. Padding your portfolio with these predictable performers can act as a defense against sudden swings in the stock market.
- Low-risk: Defensive stocks are often attractive to investors who prioritize protecting their wealth against loss. These low-risk companies maintain their value, and investors' capital, value over time.
- Outperform in periods of economic decline: When the economy drops, defensive stocks tend to outperform their cyclical peers. In theory, this can provide some balance to any losses experienced by the growth stocks during a recession.
Disadvantages of defensive stocks
- Low-growth: The flipside of stability is that defensive stocks rarely experience rapid growth. They might preserve their value over time, but you're probably not going to get rich off of them.
- Underperform in periods of economic growth: When the economy is on the rise and other stocks are soaring, defensive stocks are more likely to stay where they've always been in terms of growth. In fact, they typically underperform when the market is up. This means that holding too many defensive stocks can drag down your portfolio when the market is doing well and prevent you from taking advantage of these spikes in the economy.
- Can be overvalued: Defensive stocks are often overvalued in periods of economic decline. If you're going after a stock because you're worried about the economy and perceive it as a safe bet, chances are high that a lot of other people are doing the same thing. This can lead the stock to take on an artificially inflated value during a downturn.
The financial takeaway
In the end, a defensive stock is any stock that performs consistently regardless of changes in the market. While looking for stocks in defensive sectors is a good starting point, it's more important to pay attention to the relevant features of an individual stock (company size, dividend payout, and historical returns) that suggest it will perform defensively.
Defensive stocks can help you preserve wealth and protect yourself against losses during a recession. However, these stocks are unlikely to provide super-powered growth.
Conservative investors and investors who are investing to preserve capital often lean toward defensive stocks because of their reliability, while more aggressive investors may avoid defensive stocks altogether: Living by the motto that "offense is the best defense," they prefer to bet on cyclical stocks that offer waves of high growth they can ride out through periods of economic decline. Or, they protect their wealth by maintaining a buffer in cash and/or bonds.
In the end, defensive stocks are just one of several investment tools you can use to mitigate risk in your portfolio, and most investors will want a diversified strategy that combines them with the right cyclical or growth stocks. Like most things in life, investing is all about finding the right balance.
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