How has a company or sector changed over time? It’s also important to recognize that even which stocks fit the traditional definition of “defensive” changes over time. For example, while healthcare stocks are viewed as more defensive today, they were significantly more sensitive to economic and market conditions 15 years ago and their sensitivity may change again with the new healthcare law. Similarly, the technology sector used to be the antithesis of defensive back in the 2000s, but since then, many of the surviving technology stocks have become large, reasonably stable businesses. As a result, the sector is less sensitive now to the market than it has been in the past. Meanwhile, in contrast, the financials sector has moved in the opposite direction and may move again amid increasing regulations. The key point here is that exactly how defensive a stock is, and even whether it’s defensive in the first place, actually changes over time.
The cost of the defensive strategy. Finally, it’s important not to overpay while seeking safety. Insurance is a wonderful thing, but if the cost of the premium is too high, you may be better off accepting the risk. Today, some of the defensive sectors, such as utilities and consumer staples, are expensive, meaning you may be paying a very large premium to get only short-term risk mitigation. In my opinion, this may not be worth it. In a similar way, investors often overpay for a hedge. This is particularly risky at a time when unconventional monetary policy is still distorting pricing in many asset classes.
In short, defensive companies and sectors play a vital role in a portfolio. That said, defensive companies are not a free lunch.
Source: Market Perspectives, “Understanding Defensive Stocks and Their Tradeoffs”.
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog and you can find more of his posts here.