Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk.
Take stocks for example. Some are more risky and volatile than others, but may have much higher potential for gains. You must learn the characteristics of the kind of stocks you are investing in. Stocks can be broadly classified into two groups: Defensive stocks and Cyclical Stocks.
What Are Defensive Stocks?
Defensive stocks are stocks of companies that sell a product or a service that is a necessity. Whether the economy is doing well or in a recession, people will still have to buy their products.
Health care, utility and consumer staples companies will not see demand for their products fall much, even during a recession. They will still be able to increase or maintain their revenues regardless. Because their revenues and profits are more predictable, the prices of their shares tend to be relatively much more stable as well. However, these companies tend to grow at a slower pace.
Defensive stocks tend to have a low ‘Beta’ value. When the overall stock market (measured by the index) goes up by 10%, defensive stocks may rise less (e.g. 5%). At the same time, if the stock market plunges by 10%, defensive stocks will fall by a smaller amount (they may even rise at times). Therefore, defensive stocks outperform the market during market downturns and underperform the market during market rallies.
So, the best time to hold defensive stocks is when you anticipate a recession coming. During stock market rallies and economic booms, defensive stocks tend to start slowing down. If you are the kind of investor that does not like much volatility and are willing to get slightly lower returns over the long-term, then you may want to hold more defensive stocks in your portfolio.
What Are Cyclical Stocks?
The opposite of Defensive stocks would be Cyclical Stocks. Cyclical stocks are stocks of companies that sell products or services that are a ‘luxury’ as compared to a necessity. These include companies that sell cars, high-end retail, computers, houses and travel services.
During economic expansion, people feel richer and tend to purchase more luxury goods. Businesses start to expand more and therefore; the stock prices of these cyclical companies tend to increase rapidly during these good times. However, during an economic slump, consumers and businesses will reduce the purchases of these good and services. This is when the cyclical companies will suffer huge falls in their sales and profits. As a result, their stock prices will fall hard as well.
Therefore, Cyclical Stocks have a high level of correlation to the economy and the overall market (high Beta). When the stock market rises, cyclical stocks will lead the way, rising even faster. When the stock market falls, cyclical stocks will come crashing down even harder.
The best time to buy cyclical stocks is when the stock market starts to recover from the bottom of a downturn and when investors anticipate that the economy is bouncing back. The time to get out of cyclical stocks is when the economy starts to falter and a recession is looming.
You have to know how to balance the number of cyclical and defensive stocks, depending on where you are in the economic cycle and depending on how aggressive or risk averse you want to be.