A lot of Wall Street banks' sell side analysts are presently suggesting that you should pick defensive stocks to protect against difficult economic times. Defensive stocks are companies in food, drugs, health care, utilities and consumer staples. It's just dumb.
The logic of course is that to spread risk, you should have a diversified portfolio of assets; in other words, a spread of cash, stocks, bonds, real estate, commodities and gold. As we are all bad at market timing and economic analysis, we will benefit by having this spread of assets. We no longer have to decide on the next recession or buying levels for any asset. There are no sleepless nights, wondering if you have just missed a major top or bottom in any one of the markets. I have no problem with this strategy, it is probably the best way to make money in the long term. The other major consideration for portfolio selection is the required income from the portfolio.
So you have decided on an asset allocation for your portfolio that suits your risk profile and your need for income. This will be different for all investors. Some investors are more risk tolerant and some are cautious. Some portfolios have no need to generate income and others are purely based on the income that they produce. The asset allocations will reflect these choices. If you are not making these decisions, you are either a trader at heart or you are not investing wisely (and probably not successfully either). Personally, I like to make calls on the economic environment and often have asset allocations that are very unusual. That is my preference. However, I am always aware of the asset allocation and the risks of the choices that I have made.
If you are a disciplined investor, your asset allocation will be set and you will not change it unless your risk tolerance or your need for income changes. In that portfolio of assets, there will most likely be some allocation to stocks. If you have no allocation to stocks in your choice of assets (which is fine), this article is wasted time. If you have the allocation of stocks, it is because it fits with your risk profile and your need for income.
So the question is -- what decision have you made by moving to defensive stocks? There are 3 potential answers:
1. If the decision is due to your risk profile changing, you should change your asset allocations in a way that helps you manage your risk. This would not involve buying defensive stocks as this is just moving assets around in an allocation.
2. If you need more income the same is true, you need to change your asset allocation. This may, however, involve buying defensive stocks if you do not want to change your risk profile. This would be because the stocks you change to have a greater dividend yield not because they are defensive. You want the risk of owning stocks but need some more income.
3. If you are making a market call (that the market is going to fall), you should sell stocks, not change into defensive sectors. Defensive stocks will fall less in the drop but they will fall all the same.
There is no reason to be moving into defensive sectors unless you are investing without any discipline. You should be moving into another asset altogether if your risk profile or your income needs change. My advice is - be aware of why you are making a change. If it is because you are hesitant about the future then sell stocks, do not buy defensive sectors. Move the money into sectors that will provide you with income (bonds) until you are happy with the economic environment. If you are really worried, move to cash. Be aware that doing this is making a market call and you may be wrong!
The last reason that defensive plays are recommended is to cover the "I was wrong selection." By this, I mean that you are worried about the economic environment and so want to call the market lower. However if you are wrong and the market heads back up (making your market call wrong), you will have lost all of the gain. By buying defensive stocks you have hedged your bets; you will gain if you are wrong and lose less if you are right. So what have you done here. You have reduced your risk, nothing more, nothing less. What should you do if you want to reduce your risk -- change portfolio allocations! If you move wisely, you will likely make some income whilst you wait for a time when you are happy to take more risk again.
One last point I want to make here. In general defensive sectors have greater dividend yields. Higher dividend yields are paying you to take the risk of owning the stock. If you are choosing dividend stocks, be sure that you are aware that you are still taking a greater risk than you would if you owned the senior debt of the same company. Defensive stocks with low dividends have no redeeming features in my opinion.
Owning dividend stocks is a different argument to owning defensive sectors. This article is not about dividend investing. Here is a CNBC article on defensive stocks from the 14.6.2012 by Russ Koesterich. Here is another by the WSJ online. I don't agree with either. If you want to take the risk in your portfolio of owning stocks, choose the companies that you think will be the best performers. This may be Apple (AAPL) or Amazon (AMZN), Exxon Mobile (XOM) or Microsoft (MSFT), Goldman Sachs (GS) or JPMorgan (JPM); whatever you think is the best selection. Understand that you are taking a greater risk with your money when you do this and the losses may be greater. If you want to reduce the risk in your portfolio, change the asset allocation (put more assets into bonds and cash) not the selection of assets in the asset class. Moving assets in an allocation class is a sure fire way to underperform.
I often think about the reasons that I am making changes to my portfolio. If I can identify the true reasons that I am buying or selling, I can often avoid mistakes. All of these recommendations for defensive stocks are poor thinking in my opinion. If you want to follow them, go through a logical thought process to ascertain why you are moving in to defensive sectors. If this thought process has flaws, don't follow it despite its initial attraction.
Disclaimer: This article is not intended as investment advice. Before taking any action, please do your own research. Do not rely on any opinions or facts included in this article for decision making.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Long RWM, RIMM, USD/JPY, various U.K. corporate bonds.