The Hidden Dangers of Defensive Stocks
Holding defensive stocks is important to even the most aggressive portfolio. They can help balance out volatility and returns through steady gains and dividend payments. If the market undergoes a correction, defensive stocks typically hold their ground relatively well – and could even go higher depending on the industry. But defensive stocks are often misunderstood by investors who think that they are immune to danger.
All stocks, defense included, are subject to similar risks, like interest rates, foreign exchange rates, economics and more. What makes a stock defensive is it’s resistance to economic pullbacks. Typically a stock that has a large market cap, pays a dividend and in an industry that’s non-cyclical is considered defensive. Investors need to keep in mind though that defensive stocks have weaknesses all their own though and aren’t always the best choice to load up in your portfolio.
Key dangers of defensive stocks
One of the most common risks associated with defensive stocks is opportunity cost. Hedging your bets can help reduce your exposure to risk, but it comes with a price. Taking the safer course can sometimes mean missing out on better gains elsewhere.
When the economy is strong, being more aggressive is a better strategy, even if you’re conservative. Being too safe with your investment picks means under-performing indexes like the S&P 500 and resulting in a portfolio that doesn’t meet expectations. Avoiding loss doesn’t mean much if the end result is still too low to provide for retirement.
Another risk that can be associated with any stock is overvaluation. Many conservative investors tend to ignore the fact that defensive stocks can become overvalued, but when demand is high and volatility is trending higher, defensive stocks slowly lose their power. Investors begin buying these types of stocks en masse and valuations grow higher defeating the purpose of holding a stock with a low price-to-earnings ratio.
Finally, one of the biggest benefits to holding a defensive stock is the dividend yield. This steady stream of income not only helps bolsters total annual returns, but also provides some downside protection. But dividends can make some investors complacent when they should be concerned.
Dividends aren’t guaranteed. Some companies offer dividends that exceed income making them poor choices for an investment. Eventually the company will have to cut its dividend to reduce outgoing payments and become cash flow positive. Investors should be wary of companies that are paying dividend’s well in excess of its peers.
Diversification is still the best defensive strategy for any portfolio. Even if you’re a conservative investor, holding only defensive stocks subjects you to risks that more aggressive investors won’t have to worry about. Mixing in various stock types gives a portfolio the best variety to weather any economic storm.