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Why invest in defensive stocks? Research Team | Posted On Wednesday, July 30,2014, 12:40 PM

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Why invest in defensive stocks?



In times of a booming/bull market stocks sell like hotcakes. “A rising tide lifts all boats” and in such times mediocre and even poor stocks rise rapidly. This party cannot go on forever and when stocks rise too fast too soon being cautious is advisable.

Stocks are regarded as risky investments. Stocks are known to give high returns with high risks. Is it possible to create a portfolio of stocks which are protected from extreme volatility (fall in the stock market) called an ideal portfolio?

Business cycle/Economy

Stock markets move in line with the economy (business cycle).

  • When the economy is in a slowdown or a downturn, stock markets crash. You have a recession.(Bear market).
  • When the economy is in recovery or an expansion stock markets rise. You have booming markets (Bull market).

What are defensive stocks?

Defensive stocks are mainly from sectors which you cannot do without.
FMCG : Think toothpastes, perfumes, soaps, detergents. You will not stop taking a bath, washing your clothes, using your deodorant or an aftershave just because the market is in recession. The fast moving consumer goods industry manufactures these essential items and are relatively unaffected in a falling market.
Pharmaceuticals : You have to take your medicines whatever be the state of the economy. You cannot say the markets are in recession and the purchase will be made when the markets are back on track. Pharma Companies manufacturing these essential drugs/medicines are immune to a recession.
IT : Software Companies sell their products abroad and in times of a recession the rupee generally becomes weaker (loses value) against the dollar. Software Companies get paid in dollars as they sell products abroad and these dollars fetch more rupees when exchanged in India. IT Companies tend to do well in these recessionary times.

See Also: Stock Exchanges In India

What are cyclical stocks?

Cyclical stocks or growth stocks are the opposite of defensives. These stocks rise rapidly in a booming market even faster than the stock market itself.
Automobiles : You would purchase an automobile in a booming market as you are in a spending mood. You are willing to even take a loan as the markets are positive and automobile Companies benefit in this situation. (Booming markets).
Housing /Infrastructure : In a booming market you would think of purchasing your dream house even availing a home loan to do so. Infrastructure and even cement stocks do well in a boom market as they are necessary for construction.
Banking : In times of easy credit (everyone is taking loans) and the banking sector benefits from this. Banking stocks rise rapidly.

How do you identify defensive stocks?

  • If stock markets rise rapidly it is called a bull market. Certain stocks rise even more faster than the stock markets called cyclical stocks. These stocks also fall lower than the market in a recession.
  • A defensive stock rises in a bull market but at a rate much slower than the stock markets. The defensive stocks remain steady in a falling or a recessionary market.
  • A defensive stock pays good dividends. These Companies pay you dividends over a long period of time (good track record for dividend payouts).

What are the benefits of a defensive stock?

A defensive stock rises in value during a recession as everyone rushes to purchase them. As the demand for them rises so does their price.

This is a time when cyclical (Banking ,automobile,infrastructure,housing,cement) stocks fall down and the value of your portfolio is eroded. Defensive stocks prop up your portfolio in these recessionary times and the value of the portfolio is protected.

As defensive stocks pay dividends it serves as an added bonus to the returns you would get if you sold them in a bear market.

When should you purchase a defensive stock?

If you purchase a defensive stock in a recession its price will be sky high. You would have to pay a huge amount for these stocks. During the start of a bull market you need to pick up cyclical/growth stocks as these rise rapidly and give a good profit.

The best time to purchase defensive stocks is at the start of the decline/fall of the bull market. Defensive shares at this time are available at relatively cheap prices.

This is the time when everyone sells growth/cyclical shares and the market crashes. The trend is that stocks are dangerous and they are dropped like hot potatoes. This is the time to pick up defensive shares.

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