Defensive stocks

Some businesses sell things people need whether the economy is booming or shrinking. Medicine is the clearest example — people do not stop buying it in a recession.

Shares of such businesses are called defensive stocks. Their demand does not swing much with the ups and downs of the economy, so their revenues, and often their share prices, are steadier too.

The workbook introduces defensive stocks as a tool for managing unsystematic risk — the risk specific to a company or sector, such as demand cyclicality, that diversification can reduce or eliminate. Its own definition: "Defensive stocks are stocks of those companies whose product demand and revenues are less influenced by economic cycles."

Its example: demand for medicines and health services is typically insulated from contraction and expansion in the economy and individual incomes — people need healthcare regardless of whether GDP is growing or shrinking.

Defensive stocks sit opposite systematic risk factors, such as inflation or political risk, which apply across the board and cannot be diversified away — defensive stock selection addresses only the company- and sector-specific part of total risk.

A retirement portfolio holds equity across two sectors: a consumer discretionary company selling premium furniture, and a pharmaceutical company manufacturing essential medicines.

During a recession, the furniture company's sales fall sharply as households postpone big-ticket purchases — its share price drops 30%. The pharmaceutical company's revenue barely moves, since people keep buying prescribed medicines regardless of the state of the economy — its share price falls only 5%. Holding the pharmaceutical company alongside the furniture company reduces the portfolio's exposure to the specific risk of discretionary-spending cyclicality, which is exactly the diversification benefit the workbook attributes to defensive stocks.

Chapter 5, section 5.3.2 (Beta), introduces defensive stocks as an example of diversifying away unsystematic risk, in a footnote to the discussion of systematic versus unsystematic risk. Expect a question asking which type of stock is least affected by the business cycle, with healthcare or FMCG-type examples in the options.

• Defensive stocks reduce unsystematic (company/sector-specific) risk, not systematic risk. Inflation, political risk and other economy-wide factors still affect a portfolio holding only defensive stocks.
• The workbook's named example is healthcare/medicines — do not assume any low-volatility stock automatically qualifies as defensive; the defining feature is insulation from the business cycle specifically.
• Do not confuse "defensive" with "safe from loss." A defensive stock can still fall in value; it simply falls less in response to economic swings than a cyclical stock.