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The entry point into a discussion of the difference between defensive stocks and cyclical stocks is how you as an investor build and manage a portfolio that pertains to your investment strategy. Specifically, investment strategies are based on your approach to the relationship between risk and return. Defensive and cyclical stocks feature quite different risk and return profiles.

Diversification is one of the basic concepts every investor, both individual and institutional, needs to be familiar with. It is central to modern portfolio theory, which is concerned with maximizing return at a given level of risk or minimizing risk at a given level of return.

Many investors rely on diversification to sleep soundly at night. This is because diversification reduces the risk unique to each stock, called company-specific risk. Also referred to as unsystematic risk, company-specific risk is not correlated with stock market risk or return. Up to a certain threshold, the more securities held in a portfolio, the more that company-specific risk is reduced.

However, all stocks are subject to market risk, called systematic risk. But not all stocks are impacted by market risk to the same degree, as is the case with defensive and cyclical stocks. These stock types feature general differences in beta, which is a measure of the degree to which a stock’s price moves relative to the market as a whole.

Beta is a measure of a stock’s risk relative to the market, usually the S&P 500 index. A beta higher than 1.0 indicates that, on average, when the market rises, the stock will rise to a greater extent and when the market falls, the stock will fall to a greater extent. A beta lower than 1.0 indicates that, on average, the stock will move to a lesser extent than the market. The higher the beta, the greater the risk.

Another way of putting it is that defensive and cyclical stocks aren’t correlated in the same way with the market. Building a portfolio with a mix of uncorrelated assets is a key part of diversification.

On a basic level, we understand the desire to maintain a portfolio with a diverse set of stock types, including defensive and cyclical. But what are defensive and cyclical stocks, and how do you select them?

Cyclical Stocks

Cyclical stocks watch their share prices rise and fall at the discretion of consumers. Cyclicality refers to the correlation of a company’s profitability and its related stock price with the movement of the economy.

When the economy is expanding or recovering from a recession, share prices of cyclical stocks rise reflecting the improving prospects of the cyclical companies; when the economy is contracting (or is expected to contract), share prices of cyclical stocks fall as investors rotate out of cyclical stocks and into defensive stocks or growth stocks.

Cyclical companies’ in-step movement with the economy is called a positive correlation. Not every cyclical stock will have a beta measurement above 1.0, but, compared to defensive stocks, cyclical stocks’ beta measurements will likely be higher. This also depends on the sector and industry, as well as the current economy.

To imagine a cyclical stock, think of how you spend your discretionary money. Cyclical stocks are also called consumer cyclicals and merit their own market sector. Industries within this sector include auto and truck manufacturers; hotels, motels and cruise lines; restaurants and bars; most retailers; and home furnishings.

Banks are not considered cyclical stocks in the sense of being part of the consumer cyclicals sector. However, banks and other financial services companies, such as insurance providers, do see their business prospects change under different economic pressures.

An oil and gas exploration and production company, such as Occidental Petroleum (OXY), is an example of a stock that is part of a sector (energy) that is subject to intra-sector cycles based on supply and demand.

Cyclical stocks are hard to select just on a basis of market correlation because investors cannot accurately and regularly predict economic and market cycles. The corona-virus pandemic is an example of a black swan event, wherein an unpredictable change puts recessionary pressure on the economy.

Economic and market disruptions are hard, if not impossible, to predict. The pandemic ended the longest bull market in history, which originated in the recovery from the Great Recession of 2007 to 2009.

The other factor to consider is that the market is forward-looking, so the share prices of cyclical stocks will likely start to rise before the economy bottoms out and prices will start to weaken before the economy starts to turn down.

Defensive Stocks

Defensive stocks shield your portfolio from severe downturns in the economy and the stock market. In fact, stocks that fall under the defensive category normally have low or negative correlation between their profitability and the movement of the economy and the market, up or down.

Their defensive status comes from their overall stability in relation to more volatile stocks and at the typical cost of less appreciation and growth when the economy is strongly expanding.

Defensive stocks have no correlation between their profitability and the economy; some defensive stocks are called non-cyclical. The goods and services of non-cyclical stocks have what is referred to as “sticky” demand. Consumers need the products these companies provide no matter what the condition of the economy is.

Typical defensive sectors include utilities, consumer non-cyclicals or staples, health care and telecommunications services. Companies such as Tyson Foods Inc. (TSN), a food manufacturer and processer; Procter & Gamble Co. (PG), a personal products manufacturer; and Philip Morris International Inc. (PM), a tobacco company, are examples of consumer non-cyclicals.

However, a defensive stock is not simply a company that falls into a specific sector or industry. A truly defensive stock should exhibit basic traits in relation to its business fundamentals.

A defensive stock is an established company with a history of success, usually with a market cap in the billions. The company typically pays a dividend and has done so consistently for a long period, at least for a decade. It should be able to maintain its dividend throughout the economic cycle. In terms of volatility, the stock has a low beta, below 1.0.

Investors can also think of blue-chip stocks as being defensive stocks, though they are not necessarily non-cyclical stocks. Blue chips are considered high-quality investments in mature companies that dominate an industry. They are considered to be a low-risk stock investment.

Conservative investors are attracted to defensive stocks because they offer an opportunity to preserve their principal and their investment gains. These investors are attracted to the advantages of defensive stocks: stability, lower risk and outperformance during periods of economic decline.

Conversely, aggressive investors eschew defensive stocks because their advantages are viewed as disadvantages. Aggressive investors primarily seek growth from stocks in the form of capital gains. Defensive stocks producing consistent returns based on non-cyclical patterns are typically not growth stocks.

Although defensive stocks may outperform cyclical stocks during periods of economic decline, defensive stocks tend to underperform cyclical stocks when the economy heats up again and the market becomes bullish.

In market recovery, upswings out of a bear market may account for strong sudden growth for many stocks. Defensive stocks usually miss out on this trend due to their low beta and may even see their share prices fall as investors rotate their portfolios away from a conservative strategy into a more aggressive one.

It is also possible for defensive stocks to become overvalued when investors rotate into a defensive strategy en masse. For this reason, it is generally not a good idea to try to time the market or make wholesale allocation changes during economic upheavals.

Conclusion

Cyclical stocks’ profitability is tied to the status of the economy: Share prices rise when the economy is expanding and fall when the economy is contracting. Defensive stocks in general do not lose their value as the rest of the market does during periods of economic downturn. Stocks are deemed defensive that have stable sales and earnings, essential consumer products with sticky demand, a long history of surviving through economic cycles and paying dividends and lower volatility.

If you want to benefit from the upswings of cyclical stocks and the stability of defensive stocks, the best way to do so is through a diversified portfolio. For the average investor, beating the market is usually easy to achieve if you are not chasing gains; most of the battle is in preventing easy losses.

Following a portfolio allocation strategy that covers diverse parts of the market ensures that you are exposed to the right types of stocks at the right times. This is an effective way to keep your portfolio from tipping too far in one direction during different economic cycles.