Business & Finance / Tuesday, June/04/2024 / 11

Understanding Defensive and Cyclical Stocks

One of the ways investors classify stocks is by type of business. The idea is to put companies in similar industries together for comparison purposes. Most analysts and financial media call these groupings ?sectors? and you will often read or hear about how certain sector stocks are doing.

One of the most common classification breaks the market into 11 different sectors. Investors consider two of there sectors ?defensive? and the remaining nine ?cyclical.? Let?s look at these two categories and see what they mean for the individual investor.

Defensive

Defensive stocks include utilities and consumer staples. These companies usually don?t suffer as much in a market downturn because people don?t stop using energy or eating. They provide a balance to portfolios and offer protection in a falling market.
However, for all their safety, defensive stocks usually fail to climb with a rising market for the opposite reasons they provide protection in a falling market: people don?t use significantly more energy or eat more food.

Defensive stocks do exactly what their name implies, assuming they are well run companies. They give you a cushion for a soft landing in a falling market.

Cyclical stocks

Cyclical stocks, on the other hand, cover everything else and tend to react to a variety of market conditions that can send them up or down, however when one sector is going up another may be going down.
Here is a list of the nine sectors considered cyclical:

Basic Materials
Capital Goods
Communications
Consumer Cyclical
Energy
Financial
Health Care

Technology
Transportation

Most of these sectors are self-explanatory. They all involve businesses you can readily identify. Investors call them cyclical because they tend to move up and down in relation to businesses cycles or other influences.

Basic materials, for example, include those items used in making other goods ? lumber, for instance. When the housing market is active, the stock of lumber companies will tend to rise. However, high interest rates might put a damper on home building and reduce the demand for lumber.

How to Use

Stocks sectors are helpful sorting and comparison tools. Don?t get hung up on using just one organization?s set of sectors, though. MorningStar.com uses slightly different sectors in its tools, which let you compare stocks within a sector.
This is extremely helpful, since one of the ways to use sector information is to compare how your stock or a stock you may want to buy, is doing relative to other companies in the same sector.

If all the other stocks are up 11% and your stock is down 8%, you need to find out why. Likewise, if the numbers are reversed, you need to know why your stock is doing so much better than others in the same sector ? maybe its business model has changed and it shouldn?t be in that sector any longer.

Conclusion

You never want to be making investment decisions in a vacuum. Using sector information, you can see how a stock is doing relative to its peers and that will help you understand whether you have a potential winner or loser.