The equity market is rife with exciting investment opportunities. However, at the same time, it is also highly unpredictable. Amid this chaos, investors are always trying to understand the market better that will help them make better investment choices. This leads us to the topic of cyclical vs defensive stocks, and which is better for your portfolio.
Finding the right stocks to invest, that will give steady long-term returns with minimum risk exposure is a challenge. For that, you need to understand which stocks are suitable for investment and will generate a good profit.
Let’s take a closer look to understand what cyclical and defensive stocks are, their differences, and how they influence your portfolio performance.
As the name suggests, these stock prices show a cyclical movement and susceptible to sporadic price changes. These shares are influenced by macroeconomic factors, systematic changes, rise and fall of disposable income, and more. These are the shares from companies/sectors that are influenced by the shifts in the economy. Let’s try to understand it better with an example.
When the economy is booming, and people have more disposable income in their hand, they invest in luxury products to upgrade their lifestyle. Sectors like the automobile, infrastructure, consumer durable, fashion lines, airlines, entertainment, thrive during this phase. Their sales soar and also the prices of their shares. These sectors follow all the cycles of the economy – expansion, peak, and fall.
Because of this nature, cyclical stocks are very volatile, but since investors can’t control economic cycles, they need to adjust their investment practices to ride the tide better.
On the other side of the spectrum are the non-cyclical or defensive stocks. These are the shares from companies which produces daily utility products, FMCG, – sectors which are virtually immune to market changes. Because of this trait, non-cyclical stocks are also called defensive stocks. Defensive stocks are steady earners and often outperform cyclical stocks when economic growth is slow.
One example of a defensive stock is non-durable items. No matter what economic conditions are, people will continue to buy things like toothpaste, soaps, and detergent, because these are essential items.
Another example is the utility sector like gas, energy, electricity, and more. Irrespective of economic condition, defensive stocks grow at a conservative pace and aren’t susceptible to sudden price changes. These stocks offer a risk hedge against unexpected market movement but at the same time, aren’t spectacular earners.
Investing in defensive stocks during economic slowdowns is an excellent way to avoid losses and hedge against market volatility.
The blue line represents the stock prices of Ford Motor between 2000 and 2002. You can see that there are sharp rises and falls both depending on the economy. However, the red line, representing a defensive stock, has remained steady during the period and even outperformed Ford stocks eventually.
Comparative Analysis Of Cyclical vs Defensive Stocks
|Nature||Performance depends on the economy||Steady performance even during slowdowns|
|Examples||Automobile, Consumer Durables, Infrastructure||Utilities, FMCG|
|Risk||High in risk||Low in risk|
|Beta||Higher than 1||Lower than 1|
|ROI||40-50 percent within one year when the economy is good||50-60 percent within one year irrespective of economic condition|
Cyclical vs Defensive: How To Make Your Investment Choice
So, which one will you choose? As an investor, it becomes critical to select the right shares that will increase portfolio income but will also help you mitigate risks when the market is slow. Stock prices are subject to changes based on economic performance. But some stocks are more prone to hostile changes due to macroeconomic changes than others. You’ll need to tailor your investment practices to absorb these changes.
The key is to understand the nature of the stocks and how they respond to the economy. It is called a top-down approach. The other method is bottom-up, in which investors thoroughly investigate the company, its background, financial performance to make an investment decision.
Secondly, look at long term investment. Staying invested for an extended period helps you better adjust to market risks.
Overall, decide your portfolio based on your nature as an investor and abilities to adjust to market risks. Ideally, a balanced portfolio must contain both cyclical and defensive stocks to enjoy steady income at minimum risk.