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Importance of Owning Both Defensive and Cyclical Stocks

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Sectors and styles

Industries respond differently to different parts of the business cycle. For example, cyclical sectors, such as technology and discretionary consumer goods, generally benefit from economic upturns. On the other end, defensive sectors, such as food staples and utilities, are the last areas that people cut back on when times are tough. There are also certain styles of stocks to consider, such as value or momentum, and, for certain investors, some smart beta strategies may be an alternative to consider to help you access those styles. In short, cycles turn, so you probably want to make sure you’re not over-concentrated in one area.

own both defensive and cyclical stocks

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Market Realist – You should own both defensive and cyclical stocks to optimize your equity portfolio.

Cyclical industries like technology (XLK) and financials (XLF) tend to perform differently from defensive industries like utilities (IDU)(XLU) and consumer staples (XLP)(FSTA) for reasons stated above. The graph above also suggests the same.

The graph shows the correlations between technology stocks, financials, utilities, and staples. As you can see, technology and financial stocks are less correlated to utilities and staples.

The correlation between technology and financials is quite high at +0.79. This is because the two tend to behave similarly at a given phase of a business cycle. The correlation between technology and utilities is quite low at +0.44. The correlation between technology and staples is slightly higher at +0.65. Financials are less correlated to the defensive sectors.

The defensive sectors cushion the fall in the cyclical industries in risk-off scenarios. As a result, they help stabilize your portfolio during volatile times. However, the cyclical industries outperform the defensive industries when the economy is improving. A good mix of the two industries improves your portfolio’s performance.

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