Defensive stocks

Investors who enter the stock market always do so in hopes of making money. Some investors who prefer short-term trading find growth stocks that may be volatile. Only through volatile stocks that show considerable price movement can such investors make huge profits. However, the price movement is not always positive and can force these investors to incur losses.

Apart from investors that rely entirely on the increase in the stock price to make money, there is a different breed of investors who believe in value investing. Value investing is when you buy value stocks and hold them for the long term, at least for 10-15 years. The aim for these investors is not to make profits by selling the stocks but to use the asset class to realize steady returns as dividends. These investors believe that investing huge amounts in various dividend-paying stocks is safer than investing in volatile stocks. As they are promised regular dividends, they don’t have to sell the shares and still get the money that they can use for their expenses.

But where do they invest? What types of stocks provide them with steady returns? The answer lies in Defensive Stocks. But first, let’s understand a little about dividend payouts.

What is a dividend?

When you buy the shares of a company, you become the shareholder and gain ownership of a part of the business based on the number of shares you hold. As a shareholder, you are entitled to a portion of the profits of the company if they decide to distribute them to the shareholders. A dividend is the form of profit distribution of companies to common shareholders. Cash dividends are the most common type of dividend where you receive the amount directly into your trading account. The amount is entirely based on the number of shares you hold.

What are defensive stocks?

Defensive stocks are those stocks that provide constant dividends and steady earnings to the shareholders irrespective of the direction of market trend. Companies that are titled to have defensive stocks showcase a consistent demand for their products, allowing their stocks to be stable and not show volatility at par with the overall market. Defensive stocks allow investors to diversify within the asset class as they can allocate a portion of their capital to growth stocks and the remaining to defensive stocks to get assured returns.

What are the essential characteristics of defensive stocks?

First of all, defensive stocks are not similar to defense stocks. The latter are shares of companies that operate in the defensive sector and manufacture products that are used by the army forces. On the other hand, defensive stocks are those that guarantee a dividend payout and are not affected by the ups and downs in the market.

One of the main characteristics of defensive stocks is their capacity to withstand the volatility in the market. Whatever may be the trend in the market (bullish or bearish), defensive stocks do not see their value falling or rising significantly. The price movement is more sideways than upwards, which gradually increases over time. Investors do not generally buy defensive stocks to make quick profits as they do not sell them. Hence, they add to their characteristic of always being a long-term investment.

Notably, Defensive stocks are attributed with a low beta that is generally lower than 1. The beta values allow an investor to understand how much a stock can fall. For example, if the beta value for a defensive stock is 0.3, it means that if the market falls by 20%, the defensive stock would only fall by 6% (0.3x20%). The same is the case when the market rises.

Defensive stocks are also called diversification stocks as they allow investors to ensure a steady income even when the market is bearish. As defensive stocks are not affected by market swings, investors can increase their risk appetite with other investments and increase profits.

Advantages and disadvantages of defensive stocks

Defensive stocks offer considerable benefits for investors who want to realize steady long-term returns over short-term profits. As defensive stocks have a higher Sharpe ratio than the market, they offer low-risk investment opportunities for the longer term. Not to forget that they promise investors regular dividend payouts, which are added with the stocks price appreciation over time. Hence, investors who want to invest in stocks systematically without being exposed to volatility prefer defensive stocks over other kinds of investments.

Furthermore, as defensive stocks do not consider market fluctuations, they are beneficial for investors looking to safeguard their other investments when the market falls. When the market is bearish, you can not sell your stocks as they may be below the cost price. However, with defensive stocks, you can ensure you will still get the dividend amount irrespective of the market trend.

On the contrary, defensive stocks do not have the potential to offer high profits to investors. Defensive stocks do not appreciate considerably at price and may take up to a year to rise by double-digit points. Furthermore, in a bear market, defensive stocks may offer negligible dividend payout, which can further force the investors to sell them and buy them again when the prices fall.

Final Words

If you are an investor who is looking for long-term steady returns without the hassle of price fluctuations, defensive stocks can prove to be the ideal investment. You can research and identify companies that are titled to have defensive stocks and allocate a portion of your capital to hedge against the capital depreciation at the time of a bear market. However, the fundamentals and historical performance of the company must be strong before you decide to invest. For any further assistance and to find the best defensive stocks, visit the IIFL website or download the IIFL Markets app.