What Are Defensive Stocks?
Many investors use defensive stocks to protect their portfolios when markets slide. While no sector is ever completely immune to sharp drops, defensive stocks tend to outperform in tough times.
David Nanigian, assistant professor of investments at The American College, said consumer staples and utilities are some of the most defensive sectors in the market.
"This is because people will need to consume food, water, and electricity regardless of the state of the macroeconomy," he says.
Consumer staples and budget retailers It is always difficult to tell how stocks will fare in any particular climate, but consumer staples--industries that produce household items--are some of the most defensive market sectors.
Stores that sell inexpensive products to consumers can outperform when the market is down because many consumers want cheaper alternatives to high-end and luxury items.
Utilities Regardless of the market's performance, utilities are still necessary for daily life to function. Electricity, water, sewage and natural gas will provide stable returns. This results in utilities being more profitable than other stocks during bear markets. However, during bull markets, when riskier stocks promise the chance for higher returns, they will not fare as well.
Pharmaceuticals Although some people will seek alternative medicines or different avenues for recovery, pharmaceuticals can be comparatively safe from the ebb and flow of the market because challenging financial times won't change someone's need for a regular medication.
Real estate Real estate can serve as a piece of the contra market, according to William Hammer, vice president of wealth management at Vanderbilt Partners.
"Real estate (like real estate investment trusts) can also provide low correlation to the stock market in the longer-term, though it can move in similar fashion in the very short-term," he said.
Performance during bear and bull markets During bear markets--periods of uncertainty marked by falling stock prices--defensive stocks often perform better because investors are less likely to take risks. Since defensive stocks are a safe bet for stable earnings, more people will chase them, resulting in increased worth.
During bull markets--more profitable economic times--investors are more likely to prefer risky stocks, since the relative danger will be lower and the chance of success will be far greater. Therefore, during economic boom times, defensive stocks often fare worse than the market as a whole. Defensive stocks can rise when the overall market rises and in many instances are likely to do so. They just won't rise by as a big of a margin.
Beta Beta is the number that represents returns and tells whether a stock goes with or against the market.
According to Nanigian, there are three variables that impact a company's beta:
- sensitivity of cash flows to the state of the economy
- operating leverage
- financial leverage
If an asset has a beta of zero, then its returns change independently of changes in the market's returns. A positive beta means that the asset's returns follow the market, and a negative beta means that the asset's returns generally move opposite the market's returns.
"Because consumer demand for the goods or services of a defensive company is the same in expansionary periods of the economic cycle as in recessionary periods, the state of the economy has little impact on the free cash flows to stockholders in such companies. Therefore, the beta of a purely defensive stock should be zero," Nanigian says.