A good defense is the best offense, right? It’s sometimes true for investing as well. Learn more about defensive stocks and defensive sector investing.
They say the best offense is a good defense. It’s a favorite cliché among many sports coaches. And a similar principle often applies in investing. Defensive stocks and defensive stock sectors have long been a type of investment to help investors “defend” against volatile markets and economic turmoil. Defensive stocks may lack the headline appeal of more “offensive” counterparts, but that’s part of the idea.
So how do you identify defensive assets and create a defensive investing strategy? Before we tackle those questions, let’s think about why investors may want to consider a defensive posture in the first place.
The rationale for defensive investing may reflect expectations for greater volatility or uncertainty stemming from geopolitical developments beyond the control of individual investors.
A desirable long-term portfolio strategy should incorporate defensive positions or defensive elements in an effort to help protect against such uncertainty. That’s because defensive investments historically tend to exhibit lower volatility at times when the broader market experiences high volatility.
Defensive investments are built on underlying business fundamentals, which tend to be durable or resilient over long periods of time. Here are a few additional basics on defensive investing strategies.
Even if the economy takes a turn for the worse, people still need to heat and light their homes, brush their teeth, feed their families, and pay for other necessities. That’s a key tenet that makes defensive companies defensive, including businesses that generate revenue and—in theory—earnings during recessions as well as other parts of the economic cycle.
Publicly traded power producers and other utility companies may lack the capital gains potential of cyclical counterparts, such as consumer discretionary or “demand-sensitive” stocks. But such defensive assets also typically have lower downside participation during broad market downturns and can offer certain other potential benefits, such as utilities’ usually reliable dividend payouts.
Consumer staples is another example. Companies that make products consumers consistently need, regardless of the economic cycle, tend to be a top choice when the economic going gets tough.
Volatility readings—expressed through standard deviation, which measures the amount of variation of the average—are one way to gauge the relative “defensiveness” of stocks and sectors. Based on volatility benchmarks, stock prices of companies in defensive market sectors have tended to swing less widely or sharply in recent decades compared with other sectors.
For example, during the 2010s, data from S&P Global showed that the consumer staples, utilities, and health care sectors showed the lowest volatility levels over that period, with returns significantly below higher-volatility sectors like consumer discretionary, technology and communications services.
Notably, during 2020-21, the “defensive” posture of health care and consumer staples companies took on new luster as the COVID-19 pandemic swung spending toward need-based spending.
Sound portfolio strategy requires several considerations and steps, including assessing your comfort level with risk, establishing short-, intermediate-, and long-term goals, and seeking the right balance of investments. As a broad starting point or general rule, it might be a good idea to assemble a mix of cyclical and defensive investments.
It might be prudent to keep a close eye on valuation indicators—price-to-earnings ratios, for example—for individual stocks and the overall market. Has the broader market perhaps gotten a little overpriced, or “ahead of itself”? If so, that may be a good time to get defensive. As stocks rise in the absence of earnings growth, buying that incremental dollar of earnings becomes more expensive.
Also, consider watching for any cracks in the macroeconomic environment, such as escalating geopolitical tensions or signs of consumer or business weakness. Broad composites, such as consumer confidence reports, can send up red flags and help spotlight emerging trends. If economic indicators show signs of weakness or valuations appear expensive, then it’s likely time to evaluate and potentially add defensive investments to one’s portfolio.
Investors considering a defensive shift have several alternatives. They could “rotate” their exposure to fixed income assets, such as corporate bonds or Treasuries, which tend to have lower volatility than stocks. With corporate bonds, for example, investors can usually count on getting their money back along with a certain interest rate. Equities, in contrast, come with more risk of potentially losing the entire investment.
Exchange-traded funds, or ETFs, can also provide a flexible way to gain exposure to defensive sectors. But be careful. It can be prudent to shop around and to understand the ETF fee structure.
Also, make sure that a defensive ETF offers ample liquidity and trades broadly every day—small trades shouldn’t be able to move the price of the ETF.
For most investors, a defensive strategy is likely an important part of portfolio planning. But investors should also be careful about getting overweighted in any single category or overexposed to anything. Being “too defensive” could potentially lead to missed opportunities in faster-growing areas.
For clues as to whether it may be time to lighten up on defensive assets, consider watching for potential bottoming in stock valuations or for signs of improvement in macroeconomic data. After doing that research, investors may want to consider making a slow rotation into riskier asset classes.