Cyclical vs Defensive Stocks

Knowledge and strategy are the keys to a good investment. Market conditions are consistently unpredictable and investments can fail. Therefore, a good investor must know how to mitigate risk and reduce losses too. As an investor in the stocks market, it is very important to recognize different types of stocks.

Selecting the right stock is crucial in the investment process. Investors tend to invest in circular and non-circular equities depending on their needs and risk appetite. While this can get confusing, only logical and rational decisions backed by proper research will help you. Here’s a rundown of cyclical vs defensive stocks and how you can choose the right stocks for your portfolio.

Cyclical Stocks

As the name suggests, cyclical stocks are susceptible to unpredictable price changes. These stocks are dependent on the changes in the overall economy. These stocks represent the companies whose profit is higher when the economy is prospering. These companies’ returns are in tandem with the health of the economy.

For example, Tata Motors is a company that sells automobiles. When the economy is booming, people earn more. In such a scenario, more people are likely to buy cars. The sales of Tata Motors will increase and therefore, the share prices of the stock will also go up. When the overall economy is doing well, people have more disposable income to spend on luxury or expensive items. Industries like automobiles, airlines, entertainment, electronics, etc. perform well in these times. The sales for the companies in these industries increase and therefore their share prices soar.

However, when there is an economic slowdown, consumers have limited disposable income to spend. In this situation, people spend more on the necessities first rather than spending on luxuries like cars. Tata Motors’ sales performance is likely to go down. As their sales deplete, the share prices of the stock follow the same fate.

As we have seen, these stocks are volatile and highly responsive to changes in macroeconomic conditions. They follow all the phases in an economic cycle, through expansion, peak, recession, and recovery.

Defensive Stocks

Defensive stocks are the ones that are more or less immune to the changes in the market conditions. They are also called non-cyclical stocks. This is because throughout the economic cycle - expansion, peak, recession, and recovery, the stock prices do not increase/decrease according to the existing economic conditions.

Examples of defensive stock include non-durable and essential items. Regardless of the economic situation, people will continue to buy toothpaste, soap, laundry detergent, etc. as they are essential. Another group of essential items that are considered defensive stocks as utilities. Utilities such as water, gas, and electricity are basic requirements of life. As the demand for these goods remains the same at all stages of the economy, there is little impact from market changes. Large pharmaceutical companies and medical services are also considered defensive stocks because people need medical assistance regardless of their economic conditions.

How do cyclical and defensive stocks work?

A cyclical stock’s growth is dependent on the overall market conditions. In times of economic prosperity, the sales of these companies increase. As a result, the share prices also increase and the stock gives good returns. However, when there is an economic slowdown or recession, the sales drop, and therefore, the stock’s performance plummets.

In the case of defensive stocks, the returns are fairly stable. Throughout the economic cycle, these stocks tend to grow at a steady pace and rarely have considerable falls. This is because their sales are irrespective of the economic health of the country.

Benefits of Cyclical and Defensive Stocks

Cyclical: Cyclical Stocks are a boon for investors when the economy is growing. They are reactive to changes in the market. This feature makes the stocks a high-risk high-return investment. They are suitable for investors who have a bigger risk appetite. By buying cyclical stocks at the right time, an investor can reap great returns from the growth of the economy.

Defensive: They provide constant returns in the form of dividends irrespective of the health of the overall economy. At the time of recession, defensive stocks help you protect your investment. Even if the market is sluggish, you can get stable returns on defensive stocks. Investing in defensive stocks during a slowdown is a great way to avoid losses and hedge against market volatility.

It's important to understand the nature of stocks and how they react to the economy. This is known as the top-down approach. The other method is bottom-up, where investors make investment decisions by thoroughly investigating the company, its background, and financial performance.

You should also look at long-term investment. Long-term investment helps prepare for market risk. Determine the components of your portfolio based on your ability to adapt to market risk. Make sure you understand your goals, risk tolerances, and investment opportunities before you buy your stock. Keeping an eye on the portfolio is useful in the long run, as you need to be aware of the performance of all the stocks in your portfolio.

Ideally, a balanced portfolio should include both cyclical and defensive stocks. When you buy both types of stocks, you won't be crushed during a recession and you can benefit from strong economic growth opportunities as well.