Ask a Fool: What Is a Cyclical Stock?

Q: What does it mean to me as an investor if a stock is "cyclical"?

Cyclical stocks are issued by companies whose businesses and stock prices tend to follow the business cycle. They generally perform very well during economic expansions but typically underperform during recessions as sales drop.

Automakers are a good example of the type of companies that tend to be cyclical. When a recession hits, consumers can decide to wait longer to buy new vehicles, so sales fall. Airlines, hotels, restaurants, and most discretionary retailers like apparel companies also tend to be cyclical. After all, when the economy is strong, more people can afford to fly, stay in hotels, eat at restaurants, and splurge on new clothes more often.

The opposite of a cyclical stock is known as a defensive stock. These are stocks of companies that tend to perform similarly in terms of sales and profitability no matter what the economy is doing. Walmart is a good example of a defensive stock. During strong economies, Walmart's customers spend more money. During poor economies, consumers who would ordinarily shop at higher-end retailers cut back and shop at Walmart instead.

It might seem like a smart strategy to buy cyclical stocks at the start of an economic expansion and then to sell them just before a recession begins. However, while this may sound like a great idea, in practice it's virtually impossible to accurately time the economy.

Therefore, as an investor, it can be a smart idea to own a combination of both cyclical and defensive stocks in your portfolio. That way, you won't get crushed during a recession, and you'll still be able to capitalize on the growth opportunities provided by strong economies.

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Matthew Frankel, CFP® has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.