What is a Defensive Stock?
A defensive stock is a stock that provides consistent dividends and stable earnings regardless of the state of the overall stock market. There is a constant demand for their products, so defensive stocks tend to be more stable during the various phases of the business cycle. Defensive stocks should not be confused with defense stocks, which are the stocks of companies that manufacture things like weapons, ammunition, and fighter jets.
A defensive stock is a stock that provides consistent dividends and stable earnings regardless of the state of the overall stock market.
Well-established companies, such as Procter & Gamble, Johnson & Johnson, Philip Morris International, and Coca-Cola, are considered defensive stocks.
Which industries have defensive stocks?
Defensive stocks 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.
- Health care: Health care 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 have pretty stable revenue.
- Discount retailers: When the economy weakens, 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.
How to trade defensive stocks
You can trade defensive stocks with FOREX.com in these easy steps:
- Open a FOREX.com account, or log in if you’re already a customer
- Search for ‘X’ in our award-winning platform
- Choose your position and size, and your stop and limit levels
- Place the trade
- Or you can practise trading defensive stocks risk free by signing up for our demo trading account.
Why Invest in Defensive Stocks?
1. Helps reduce portfolio volatility
The defensive stock in many portfolios acts to reduce portfolio volatility. During economic recessions, investors will rely on defensive stocks to protect them from further losses. Defensive companies also provide a high dividend yield in a bear market, which makes it an attractive addition to an investor’s portfolio.
2. Serves as a viable option for less experienced investors
For investors who do not know much about the stock market, defensive stocks are a good option to start out. They allow investors to get a feel for the market first without requiring them to burn through their capital with more aggressive stocks.
For the risk-averse investor, defensive stocks are a suitable choice. It lowers the risk substantially while offering an appropriate reward.
3. Provides a steady revenue stream (through dividends)
Defensive stocks are also a good means of making income aside from shares trading. It generally provides the best dividends in both bull and bear markets, giving investors a steady revenue stream.
Lastly, there are periods in the year where the markets are neither bearish nor bullish – instead, it is highly volatile. In such circumstances, defensive stocks are one of the best investments to protect an investor’s capital and reduce risk.
Advantages of Defensive Stocks
Defensive stocks offer the substantial benefit of similar long-term gains with lower risk than other stocks. Defensive stocks as a group have a higher Sharpe ratio than the stock market as a whole. That is a strong argument that defensive stocks are objectively better investments than other stocks.
Warren Buffett also became one of the greatest investors of all-time in part by focusing on defensive stocks. It is not necessary to take excessive risks to beat the market. In fact, limiting losses with defensive stocks may be more effective.
Disadvantages of Defensive Stocks
On the downside, the low volatility of defensive stocks often leads to smaller gains during bull markets and a cycle of mistiming the market. Unfortunately, many investors abandon defensive stocks out of frustration with underperformance late in a bull market, when they really need them most.
After a downturn in the market, investors sometimes rush into defensive stocks, even though it is too late. These failed attempts at market timing using defensive stocks can significantly lower the rate of return for investors.
Examples of Defensive Stocks
Defensive stocks are also known as noncyclical stocks because they are not highly correlated with the business cycle. Below are a few types of defensive stocks.
Water, gas, and electric utilities are examples of defensive stocks because people need them during all phases of the business cycle. Utility companies also get another benefit from a slower economic environment because interest rates tend to be lower.
Companies that produce or distribute consumer staples, which are goods people tend to buy out of necessity regardless of economic conditions, are generally thought to be defensive. They include food, beverages, hygiene products, tobacco, and certain household items.
These companies generate steady cash flow and predictable earnings during strong and weak economies. Their stocks tend to outperform nondefensive or consumer cyclical stocks that sell discretionary products during weak economies while underperforming them in strong economies.
Shares of major pharmaceutical companies and medical device makers have historically been considered defensive stocks. After all, there will always be sick people in need of care.
However, increased competition from new drugs and uncertainty surrounding regulations mean that they aren’t as defensive as they once were.