Defensive stocks are those which provide constant returns in the form of dividends regardless of the fluctuations in the stock market. Because of the constant requirement of these products, defensive shares tend to remain stable during various phases of business cycles.
These stocks belong to industries that produce products that will also be in demand irrespective of economic conditions. For instance, personal care, utilities, healthcare, FMCG etc, i.e their sales are not affected by the market swings.
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The basic characteristic of a defensive stock is that it is not affected by the movements in the stock market. This can act both as a boon or a bane considering the economic structure. At the time of recession, having defensive stocks in your portfolio can actually be a blessing. Even at the downturn of the market, defensive stocks will give you stable returns. The same feature is a pain for investors at the time of economic growth as they lose the opportunity to earn high returns.
This feature of defensive stocks can be related to its low beta that is generally less than 1. For example, if the beta of the stock is 0.5, and the market is expected to fall by 10%, then the defensive stock will fall only by 5% (0.5 x 10%). Similarly, if the market rises by 20%, then also the defensive stock will rise only by 10% (0.5 x 20%).
Investors tend to invest in the best defensive stocks at the time of an expected fall in the market as this acts as a cushion against volatility. However, active investors switch to high stock beta to maximize returns at times of expected rise in the market.
Industries covered by defensive stocks
Defensive stocks also known as non-cyclical stock because they are not affected by the market swings. Following is the industry list of defensive stocks.
Utilities such as water, gas and electricity are basic requirements of livelihood. So, the demand remains the same at all phases of the economy and thus are least affected from the market changes. Further utility companies draw benefits at the time of recession as they get borrowings at lower interest rates with minimal competition.
Companies producing or distributing consumer goods usually falls in the category of defensive stocks. Consumer goods include food, beverages, certain household items, tobacco, hygiene products, etc. These are day to day use items that have a certain cash flow at all economic conditions. So, these stocks outperform during weak economic conditions and under perform during strong economic conditions when compared with cyclical stocks.
Major pharmaceutical companies and manufacturers of medical devices are considered to be defensive stocks because medical aid is required irrespective of the economic condition. But now with increase in competition from new branded and generic drugs these stocks have become less defensive.
Role of defensive stock in a portfolio
Every investor wants to protect their investment at the time of recession in the economy or from the high volatility of the market. This is where the role of defensive stocks comes into play. A steady and certain return helps the investor to survive during hard economic crashes. So, as an investor you can consider engaging a certain percentage of your investment towards defensive stocks which at times acts like a protective shield. Even big companies which have strong and steady cash flows with a fixed dividend rate for many years can be considered as defensive stocks. These big, established companies have a certain capacity to absorb market fluctuation and remain unaffected to market change.
Now as you have understood the meaning and usefulness of defensive stocks, you may think why to choose defensive stocks over risk free investment options? During the downfall of the market, why to even invest in stock when you can invest in treasury bills and other safe investment options? Yes, it’s absolutely right to choose safe investment options during the downfall of the market. But just a chance to earn dividend at a higher rate than that of interest on treasury bills with less risk attracts investors towards defensive stocks.
As an investor you should take calculated amounts of risks so that you can go through the hard times and enjoy the benefits. A proper knowledge and understanding of the market and stocks before investing will help you fetch better returns.