What are defensive stocks?

Defensive stocks are shares of companies whose products are needed in good times and bad, so their sales and profits change relatively little with the economic cycle. Classic examples are makers of food and household products, pharmaceutical and health care companies, and utilities supplying electricity and water. When the economy weakens, people still buy toothpaste and medicine and still heat their homes.

Because their earnings are steadier, defensive stocks have historically fallen less than the market in downturns — and risen less in strong markets.

How it shows in the numbers

A stock's sensitivity to the market is measured by its beta:

\beta = \frac{\operatorname{Cov}(r_i, r_m)}{\operatorname{Var}(r_m)}

Defensive stocks typically have betas well below 1, often between 0.5 and 0.8. In a market move of $\Delta r_m$ , they can be expected to move roughly:

\Delta r_i \approx \beta \times \Delta r_m

A simple illustration

A defensive portfolio with a beta of 0.6 and a cyclical one with a beta of 1.3 would be expected to move roughly as follows:

Portfolio	Beta	Market falls 25%	Market rises 25%
Defensive	0.6	about −15%	about +15%
Cyclical	1.3	about −33%	about +33%

The defensive portfolio loses less than half as much in the fall — and gains less than half as much in the rise.

What they give up

Upside in strong markets. In long bull markets led by fast-growing sectors, defensive stocks tend to lag.
Sensitivity to interest rates. Utilities and consumer staples are often valued for their steady dividends, which compete with bond yields; when rates rise sharply, they can fall.
Valuation risk. In uncertain times investors crowd into defensive stocks, which can make them expensive — and less defensive.

Defensive is not the same as safe

They still fall in a general sell-off, usually by less than the market, but they do fall.
Company risks remain. A failed drug, a regulatory change or a product recall can hit a defensive company hard.
Categories change. Parts of health care and consumer staples have become more cyclical, while some large technology companies now behave more steadily than they used to.

A share of defensive stocks lowers a portfolio's beta and its drawdowns. Beyond a certain point it mainly lowers returns, which is why the balance between cyclical and defensive holdings is a question of risk tolerance.

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