Broker Check

Defensive Stocks: A Short Explanation

June 15, 2015

Many clients are concerned with stock prices. Are they overvalued? Yes, by some measures. Are economic conditions not exactly inspiring? Yes again. Of course, many people had the same feeling two and three years ago. Imagine what would have happened if they converted their investments to cash and missed all of the last three stock market years. Fortunately, investing is not an ‘all or nothing’ proposition. You can play defense and still participate in the market rallies.

A Defensive Stock is the stock of a company whose profit growth, and therefore its stock price, has a relatively low correlation to overall economic activity. Therefore, even when the economy is not doing well, people will still purchase their soap, toothpaste, health care necessities, and food. These can be contrasted with Cyclical Stocks, which are closely tied to the economic cycle. People buy cars, big screen televisions, houses, and take expensive vacations when they are getting paid more and feel secure in their positions. However, in recent years we have seen a cyclical move upward in the stock markets due to many factors; and almost none of them have been due to great economic conditions. The conditions have been good enough, however, to push housing markets, car sales, and many other discretionary product sales up. So, depending on your view of the economic cycle in the near future and/or your general risk tolerance, you must consider when and if you want to play defense. Here are some of the considerations.

Do you really know where we are in the cycle?

Of course, the first part of the analysis is figuring out which part of the economic cycle we are in. As mentioned above, many people thought we were scheduled for a big pullback a couple of years ago. It didn’t happen. So you may not want to hang your hat on this variable when you make your determination regarding the type of stock to pick.

Where are you in your economic cycle?

Have you already reached your retirement goals? Did you already save enough for your child’s education? Or, are you a young lion making loads of money with no end in sight? Clearly, your own current financial position is the key to all of this, and should be considered when making any investment decision for defense or otherwise.

Do you understand the investment performance differences?

Generally, a defensive stock is less risky than the general stock market. If it is half as risky, then you can usually expect that it will go up half as much as the market and go down half as much, too. Therefore, if you choose to be in a defensive position, expect that the returns in a raging bull market will be well below the stock indexes. A cyclical stock will likely get more or less 100% of the market upswing… and all of the downswing as well.

I am not making any predictions here regarding the market; but if you are in the right position financially, playing some defense is something to consider. Let’s talk.

*Past performance is no guarantee of future results. Investments are subject to market risks including the potential loss of principal invested.