‘Defensive stocks’ can protect your portfolio against economic or stock market downturns

Most so-called “defensive stocks” are in the Consumer sector. They benefit from continuous, habitual use and have a steady core of sales, regardless of the economy and business cycles. These companies typically make products like soap or soup.

Defensive stocks in the Consumer sector can provide the most effective protection against economic downturns, such as the current global inflationary challenges. That’s a key difference between Consumer stocks and companies in the Manufacturing & Industry or Resource sectors, which are far more sensitive to the ups and downs of the economic cycle.

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As a general rule, resource stocks provide the most effective hedge against inflation because they directly gain from any price rise for the commodities they produce. Utility stocks used to provide a hedge of sorts against recessions, due to their steady earnings and dividends. However, that is less true today because of changing technology and deregulation in the utility sector.

However, although it pays to be aware of these general tendencies, you should resist the temptation to fine-tune your portfolio according to theories or predictions about inflation and economic downturns. No one has ever consistently predicted either one, either in timing or degree, so most investors will want to include stocks from most if not all of the five economic sectors in a well-balanced portfolio.

Strong potential for long-term gains

You will improve your chances of making money over long periods, no matter what happens in the market, if you diversify your holdings across  most if not all of the five main economic sectors: Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities.

For example, Manufacturing stocks may suffer if raw-material prices rise, but in that case your Resources stocks will gain. Rising wages can put pressure on manufacturers, but your Consumer stocks should do better as workers spend more.

If borrowers can’t pay back their loans, your Finance stocks will suffer. But high default rates usually lead to lower interest rates, which push up the value of your Utilities stocks.

Is it worth using beta scoring to select defensive stocks?

Beta scoring is a commonly used but sometimes misleading measure of volatility.

To calculate a stock’s beta, an index like the S&P/TSX Composite or the S&P 500 is assigned a beta of 1.0. The historical volatility of different stocks relative to the index is then measured using either a 36-month or 60-month regression analysis.

Beta scoring has a number of limitations

If a stock has a beta of 1.0, then it means that the market and the stock move up or down together, at the same rate. That is, a 10% up or down move in the stock market index should theoretically result in a 10% up or down move in the stock. A beta of 2.0 implies the stock will tend to move twice as much as the market. That is, if the market moves up 10%, the stock should move up 20%. A beta of 0.5 indicates the stock will move one-half as much as the market, either up or down.

A negative beta indicates the stock tends to move in the opposite direction from the general market. That is, the stock price declines when the overall market is rising, or rises when the overall market is declining.

Defensive stocks will have a low beta—they will not move up or down as much as the market, and certainly not as much as cyclical stocks.

As a measure of risk, beta has a number of limitations. It is based on past data, so its use in predicting the future assumes that the underlying company being charted remains unchanged. For example, it assumes that no major acquisitions or divestitures, or other company-changing events take place. In reality, a stock’s beta can rise or fall over a period of years, or change abruptly.

Institutional investors are always looking for so-called “quantitative” measures like beta that can be calculated automatically by a computer program. Beta makes a broad statement about a stock’s history of volatility, but it doesn’t say much if anything about its prospects or its appeal as an investment. To assess a company’s suitability for your portfolio, you are better off using other, more reliable measures of safety, such as steady earnings and cash flow, low debt and a secure hold on a growing market.

How much credence do you place in the concept of “defensive stocks” to protect your portfolio against economic downturns or even a recession? Please share your experience with us in the comments.

This post was originally published in 2016 and is regularly updated.