Consider the Distribution of Cyclical and Defensive Industries in Your Stock Portfolio - dummies

Consider the Distribution of Cyclical and Defensive Industries in Your Stock Portfolio

By Paul Mladjenovic

In analyzing your stock investments, you can neatly place most industries into one of two categories: cyclical and defensive. In a rough way, these categories generally translate into what society wants and what it needs. Society buys what it wants when times are good and holds off when times are bad. It buys what it needs in both good and bad times.

Cyclical industries

Cyclical industries are industries whose fortunes rise and fall with the economy’s rise and fall. In other words, if the economy and the stock market are doing well, consumers and investors are confident and tend to spend and invest more money than usual, so cyclical industries tend to do well. Real estate and automobiles are great examples of cyclical industries.

Your own situation offers you some common-sense insight into the concept of cyclical industries. Think about your behavior as a consumer, and you get a revealing clue into the thinking of millions of consumers. When you (and millions of others) feel good about your career, your finances, and your future, you have a greater tendency to buy more (and/or more expensive) stuff.

When people feel financially strong, they’re more apt to buy a new house or car or make some other large financial commitment. Also, people take on more debt because they feel confident that they can pay it back. In light of this behavior, what industries do you think would do well?

The same point holds for business spending. When businesses think that economic times are good and foresee continuing good times, they tend to spend more money on large purchases such as new equipment or technology. They think that when they’re doing well and are flush with financial success, it’s a good idea to reinvest that money in the business to increase future success.

Defensive industries

Defensive industries are industries that produce goods and services that are needed no matter what’s happening in the economy. Your common sense kicks in here, too. What do you buy even when times are tough? Think about what millions of people buy no matter how bad the economy gets. Good examples include food, utilities, and healthcare.

In bad economic times, defensive stocks tend to do better than cyclical stocks. However, when times are good, cyclical stocks tend to do better than defensive stocks. Defensive stocks don’t do as well in good times because people don’t necessarily eat twice as much or use up more electricity.

So how do defensive stocks grow? Their growth generally relies on two factors:

  • Population growth: As more and more consumers are born, more people become available to buy.

  • New markets: A company can grow by seeking out new groups of consumers to buy its products and services. Coca-Cola, for example, found new markets in Asia during the 1990s. As communist regimes fell from power and more societies embraced a free market and consumer goods, the company sold more beverages, and its stock soared.

One way to invest in a particular industry is to take advantage of exchange-traded funds (ETFs). ETFs are structured much like mutual funds but are fixed portfolios that trade like a stock. If you find a winning industry but you can’t find a winning stock (or don’t want to do the research), then ETFs are a great consideration. You can find out more about ETFs at the ETF Database.