Hold some defensive stock investments in your portfolio—but don’t overdo it

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.

Here’s a guide to defensive stock investing as part of a diversified, long-term-focused portfolio.

It’s important to know about cyclical sectors while considering defensive stock investments

Cyclical sectors, like resource and energy stocks, are subject to wide and unpredictable swings. In the rising phase of the business cycle, when business is booming, resource demand expands faster than resource supply, so resource prices shoot up.

Stock market cycles occur repeatedly—and there are any number of theories as to which sectors will outperform at any given short term stage of the cycle. But trying to pick winning sectors—and staying out of other sectors—seldom works over long periods. That’s because to succeed, you need to guess right twice. You have to pick the top sectors, and then pick the stocks to rise within those sectors. Consistently succeeding at both is extremely difficult.

Look for defensive stock investments in the Consumer sector

Most 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. 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.

As a general rule, resource stocks provide the most effective hedge against inflation because they directly gain from rising prices of 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.

Defensive stock investing: It takes more to succeed in diversifying your portfolio than just buying a bunch of different stocks

If you just buy a bunch of different stocks, you may wind up with a grab bag of duds. But even if you stick with high-quality stocks, you may find that many of them respond to or are vulnerable to one particular type of risk. If this one factor moves against you, your entire portfolio can suffer.

Our three-part Successful Investor strategy takes a much more disciplined approach. It tells you to spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.

When you divide the economy up along these lines, you’ll spot a lot of bad-for-one-sector-but-good-for-another connections. That’s the way things work in a free-enterprise economy.

For example, when the economy grows and inflation rises, businesses tend to borrow more money to invest. So, interest rates tend to rise. Higher interest rates raise costs for businesses, but growth in loan demand helps lenders expand. So your manufacturing stocks may suffer a little, but you get offsetting gains in your Finance sector stocks.

Growth in the economy may also push up wage rates. This hurts employers in all the sectors. But the higher wages tend to push up sales and profits of Consumer companies.

As sales rise in the Consumer sector, it leads to new business for Manufacturing companies.

This in turn leads to new business opportunities for Resource and Commodities companies, which provide raw materials for manufacturers.

You can probably think of many more examples. These are all just general tendencies, of course. But the offsets among these five factors are virtually endless. They help to limit your risk in a bad market, and help you make money in a good one.

This five-sector approach was common in the first half of the 20th century. I often heard about it in the 1970s, from a number of successful investors I met early in my career. Their views and the success they achieved had a big role in shaping my investment ideas.

Oddly enough, the five-sector approach was already on its way out when I first heard about it. That’s because it didn’t fit the needs of the investment industry.

We focus on helping investors build portfolios that generate attractive returns over long periods, and avoid deep downturns during market setbacks.

We‘ve refined the approach over the years, but it still bears a close resemblance to the rule I first heard about 40 years ago. We’ll stick with it until we find a better tool for managing investments and limiting risk.

Do you have a defensive stock in your portfolio that has been successful at creating a form of defense against market setbacks? Share your experience with us in the comments.