Defensive stocks are shares in companies that tend to be stable even during market downturns and economic slumps. These stocks provide stable earnings or returns compared with other types of stocks. They are also one of the key components of a defensive investment strategy and represent one of the common types of defensive assets and instruments. Of course, while they sound promising, they are far from perfect. This article lists and discusses the advantages and disadvantages of defensive stocks.
Pros and Cons of Investing in Defensive Stocks
Advantages of Defensive Stocks
A good defense is the best offense during a bearish market or whenever the financial markets are on a downturn. This is the purpose of investing in defensive stocks and a key principle in a defensive investment strategy. Investing in these stocks allows investors to weather through the uncertainties and emerge unscathed after market crashes. The following are the specific pros or advantages and benefits of investing in defensive stocks:
• Safer and Less Riskier: Investing in stocks have risks and other drawbacks. However, different types of stocks have different levels of risk. Defensive stocks are less riskier than cyclical stocks because they are usually more consistent in terms of providing returns or gains regardless of the condition of the stock market. They collectively have a higher Sharper ratio or return-risk ratio than other stocks.
• Better Predictability: Another advantage of defensive stocks is that they tend to have higher predictability than stocks dependent on the boom and bust of the economy due to the fact that companies offering them remain in demand. Investing in these securities allows investors to predict better how their investments will grow over time. This makes them ideal for meeting specific financial goals such as retirement planning.
• Availability of Options: There are different defensive stocks to choose from. These include stocks offered by utility companies such as energy companies, manufacturers of consumer staples, and health companies such as hospitals and pharmaceuticals. Their products remain in consistent demand regardless of the economic conditions. Some mid-cap and large-cap stocks and value stocks are also defensive stocks.
• Capital Preservation: Warren Buffett has employed a defensive investment strategy alongside his value investing principle. Note that another benefit of investing in defensive stocks is that it can create a diversified investment portfolio, lessen the risks of stock investment, and help investors preserve their wealth. Some investors have argued that defensive stocks are better investments than other stocks.
• Passive Investing: A defensive investment strategy that includes defensive stock investments is also attuned to the principles and advantages of passive investing. These stocks are ideal for buy-and-hold investing or an invest-and-forget investment mindset. They allow investors to receive substantial gains either through capital appreciation or dividend payouts with lesser risks than aggressive stocks.
Disadvantages of Defensive Stocks
Of course, when it comes to gains, defensive stocks tend to underperform compared to more aggressive stocks such as most small-cap stocks and growth stocks. Some investors often forego their defensive stocks due to the lower and slower returns. Others, especially those seeking to outperform benchmarks such as stock indices tend to steer clear of these securities. The following are the disadvantages of defensive stocks:
• Gains Are Periodic: Remember that defensive stocks are consistent when it comes to providing returns. However, during bull markets, the gains are smaller than in other stocks. This comes from the fact that these securities are less volatile than more aggressive stocks. Remember that with low risks come low returns. This might not be ideal for investors seeking short-term gains or those who want to maximize their return potential.
• Underperformance: Aside from lower gains compared to other stocks during bull markets, another disadvantage of investing in defensive stocks is that they tend to underperform in periods of strong economic growth. A stock portfolio made up of these stocks would not be able to reap the benefits of investing in a growing economy and soaring stock market or during periods of economic expansion.
• Mistiming Proneness: Some investors forego defensive stocks whenever the stock market is bullish due to the low gains they receive. However, when the market enters a downturn or is in its bearish phase, the same investors often rush into purchasing and holding defensive stocks regardless if it is too late. The fact that gains can be periodic increases susceptibility to failed market timing.
• Can Be Overvalued: Defensive stocks can be overvalued or expensive during a market downturn or when there is a widescale recession in the economy. This happens because a greater number of investors are buying these stocks, thereby resulting in an increase in demand and further driving their stock prices up. An overvalued stock will be worth less once the market corrects itself, thus resulting in price depreciation.