Table of Contents
- What Is a Defensive Stock?
- Key Takeaways
- Understanding Defensive Stocks
- Advantages of Defensive Stocks
- Disadvantages of Defensive Stocks
- Examples of Defensive Stocks
- Utilities
- Consumer Staples
- Healthcare Stocks
- Apartment REITs
- What Are Dividends and How Are They Paid?
- When Does a Poor Economy Become a Recession?
- Why Are Treasury Bills Considered Risk-Free?
- The Bottom Line
What Is a Defensive Stock?
Let me explain what a defensive stock is. It's a type of stock that gives you consistent dividends and stable earnings, no matter what's happening in the overall stock market. These companies have products with constant demand, so they're more stable through different phases of the business cycle.
Don't mix them up with defense stocks, which are from companies that make weapons, ammunition, and fighter jets.
Key Takeaways
A defensive stock provides consistent dividends and stable earnings regardless of the market's state. Companies like Procter & Gamble, Johnson & Johnson, Philip Morris International, and Coca-Cola are classic examples. They give you similar long-term gains as other stocks but with lower risk. Their low volatility means smaller gains in bull markets and can lead to mistiming the market.
Understanding Defensive Stocks
If you're looking to protect your portfolio during a weakening economy or high volatility, you might increase your exposure to defensive stocks. Think of well-established firms like Procter & Gamble (PG), Johnson & Johnson (JNJ), Philip Morris International (PM), and Coca-Cola (KO). They have strong cash flows and stable operations that can handle tough economic conditions. Plus, they pay dividends, which can cushion the stock price during declines.
These stocks are less likely to face bankruptcy because of their strength in downturns. You might wonder why anyone would hold stocks in shaky times instead of something safe like a Treasury bill with its risk-free return. The answer lies in fear and greed driving the markets. Defensive stocks satisfy greed with higher dividend yields than low-interest environments offer, and they ease fear because they're less risky than regular stocks. It takes a major catastrophe to disrupt their business model.
Most investment managers must own stocks, so they shift to defensive ones when times get tough. These stocks usually outperform the broader market in recessions but underperform during expansions due to their low beta, typically less than 1.0. For instance, if a stock has a beta of 0.5 and the market drops 2% in a week, you'd expect only a 1% loss. But if the market gains 2%, that stock might only rise 1%.
Advantages of Defensive Stocks
One big advantage is that defensive stocks provide similar long-term gains with lower risk than other stocks. As a group, they have a higher Sharpe ratio than the overall market, making a strong case that they're objectively better investments. Warren Buffett built his success partly by focusing on them. You don't need excessive risks to beat the market; limiting losses with defensive stocks can be more effective.
Disadvantages of Defensive Stocks
On the flip side, their low volatility often means smaller gains in bull markets and can create a cycle of mistiming. Many investors ditch them out of frustration with underperformance late in a bull market, right when they need them most. Others rush in after a downturn, but it's too late, and these timing errors can lower your overall returns.
Examples of Defensive Stocks
Defensive stocks are also called noncyclical because they're not tied closely to the business cycle. Let's look at a few types.
Utilities
Water, gas, and electric utilities are defensive because people need them in all economic phases. They also benefit from lower interest rates in slower economies.
Consumer Staples
Companies producing or distributing essentials like food, beverages, hygiene products, tobacco, and household items are defensive. People buy them no matter the economy. These firms have steady cash flows and predictable earnings in both strong and weak times. Their stocks outperform cyclical ones in weak economies but underperform in strong ones.
Healthcare Stocks
Major pharmaceutical companies and medical device makers have historically been defensive since people always need care. But they're less so now due to competition from new drugs and regulatory uncertainty.
Apartment REITs
Apartment real estate investment trusts are defensive because people always need shelter. Stick to those avoiding ultra-high-end apartments, and steer clear of office or industrial REITs that might see lease defaults in slowdowns.
What Are Dividends and How Are They Paid?
Dividends are your share of a company's earnings, often paid quarterly in cash or additional stock. They're not guaranteed and can be low or absent if the company has a bad quarter.
When Does a Poor Economy Become a Recession?
A U.S. recession is official only when declared by the National Bureau of Economic Research experts. It requires two consecutive quarters of negative GDP growth.
Why Are Treasury Bills Considered Risk-Free?
Treasury bills are issued by the U.S. Department of the Treasury, so buying one means lending to the government, which pays interest. They're backed by the full faith and credit of the U.S. government.
The Bottom Line
Defensive stocks give you stable earnings and dividends, less affected by the broader market. They're lower risk, but gains won't be as big, especially in bull markets. I'm not saying avoid them, but consider talking to an investment advisor about balancing them in your portfolio. Remember, the info here is for informational purposes; check our warranty and liability disclaimer for details.
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