InvestingStock Market

What Are Defensive Stocks and Why Do You Need Them?

Defensive stocks are a great tool for investors that want to minimize their risks, especially during market downturns. For example, when shares witnessed a dramatic selloff during the end of 2018, the Alliant Energy stock price barely moved. Similarly, United Healthcare stock rallied in May of 2019, even those the rest of the market declined.

Yet there are still main risks that are associated with defensive companies. An investor that holds their funds in the wrong industry or corporation is vulnerable during volatile situations. In fact, they may incur even more losses in comparison to the at-large market.

Having said all that, investors are also exposing themselves to trouble by not buying defensive stocks. Choosing the right firm and sector provides essential protection when markets are in the red. Moreover, defensive investments are very powerful when combined with other types of stocks.

Constant Demand: The Story of the United Healthcare Stock

Defensive sectors perform well, even when the at-large stock market moves down. This is because consumers will demand their products, regardless of what the interest rates are or how trade relations are going.

For example, in May of 2019, negotiations between the United States and China broke down. As a result, the Dow Jones Industrial Average (>DJI), which measures the largest 30 companies in the US, declined by about seven percent.

Meanwhile, during the same month, United Healthcare stock prices (UNH) witnessed an almost four percent climb. Why? because trade negotiations don’t have a large impact on how often patients will need medical attention.

In fact, many people start investing in these companies during market downturns. This boost in volume further increases the shares’ values.

Going back to the United Healthcare stock example, there are cyclical instances where an industry might diverge away from its defensive features. 

As the 2020 Presidential election received a lot of attention, many candidates proposed policies that, if implemented, would lower the profits of medical companies.

Because of this, these firms’ shares will drop. However, these situations aren’t very frequent.

Lower Volatility

During normal and stable market conditions, defensive stocks still increase in price. Yet the change isn’t as sizable as the at large market’s gains. In other words, while defensive sectors can protect you during downturns, the potential returns on your investment are much lower than other industries when shares are rallying.graph-3033203_1280.jpg

During the 2018 stock market selloff, as an instance, the Alliant Energy stock price (LNT) declined by only 1.1%. This is despite the fact that the Dow Jones and the S&P 500 (GSPC) indexes went down by 10% and 13.5%, respectively, between September and December of that year.

As a defensive company, the Alliant Energy stock price only witnessed a small decline. Investors who purchased other stocks, on the other hand, would have lost 13% or more.

However, when we take a step back and look at an expanded timeline, the picture looks somewhat different. During the two and half year period between June 2016 and December 2019, the Dow Jones and the S&P 500 rose by almost 54% and 61%, respectively.

The Alliant Energy stock price, on the other hand, only increased by 48% throughout the same timeframe. In short, these stocks are less risky, but the price that investors have to pay includes limited profits.

Having said all that, diversifying your portfolio makes defensive companies an especially powerful tool.

The Potential of Diversification: The Amazon vs Alliant Energy Stock Price

Defensive stocks, just as any other type of equity, have their own pros and cons. Therefore, investors should diversify their holdings in order to maximize profits and minimize risks.

To illustrate, assume that someone purchased Amazon (AMZN) and Alliant Energy in June 2016. At the beginning of the month, Amazon’s market value was almost $721 per share. The Alliant Energy stock price was about $37.

By the end of August 2018, two years and two months later, Amazon’s shares went up by over 179% and surpassed $2,000 a piece. The Alliant Energy stock price, in contrast, only gained 16% and reached $42.84 per share.

To put that into perspective, the Dow Jones’ value rose by 46.2% between June 2016 and August 2018. In other words, the investor’s returns on Amazon more than tripled the at-large market’s gains, but the profits from Alliant Energy were less than half of the Dow’s.

While this makes defensive stocks look less appealing, let’s fast forward to the end of December 2018. By that time, Amazon retreated to almost $1,500 per share and lost over a quarter of its value (25.9%) within three months.

In addition, as previously mentioned, the Dow’s losses passed 13% during that period, but the Alliant Energy stock price only shedded 1% of its value.

Not All Stocks Are Equal

It important to note that defensive companies also run into their own problems and shortcomings. Consequently, some of these corporations’ shares may be volatile and unpredictable.

For example, by the end of the day on April 15, 2019, United Healthcare stock prices closed at about $230. The next morning, after the company’s earnings outperformed analysts’ expectations, the shares were traded at $238 when the market reopened.

To clarify, that’s a 3.5% jump that only happened overnight. However, during the trading session on April 16, the company’s CEO criticized 2020 Democratic presidential hopeful, Senator Bernie Sanders, and his Medicare-for-all proposal.

More specifically, the CEO warned about the negative consequences that this policy could have on the medical industry. As a result, United Healthcare stock ended the following day (April 17) at only $216.84 per share.

In short, the company’s stocks rallied by 3.5% overnight after the earnings release, but retreated by almost 6% the following day.

Because of this, investors shouldn’t take defensive stocks for granted, regardless of which sector they belong to. You should always carefully study a company’s earnings reports, chart patterns, and other aspects before making an investment decision.

Utilities providers, for instance, are considered a main target if Iran conducted a cyberattack against the United States. After all, many business owners are already preparing for this by adding cyber protection to their general business liability insurance policies

In general, shares will go down when international tensions boil and the possibility of war increases. Yet in this particular scenario (where Iran launches a cyberattack), utility shares, such as the Alliant Energy stock prices, may decline by an even larger amount than the rest of the market.

Defensively Attackingbackground-board-chart-data-590041.jpg

To summarize, defensive stocks are a great way to minimize your risks during selloffs. The demand for health services, water, and energy will always be there. This is regardless of whether interest rates are high or low and if the United States negotiates a trade agreement with China or not.

However, investors must always carefully assess any company before making an investment decision. Otherwise, even if they buy a defensive stock, market participants could lose a lot of money by picking the wrong corporation or sector at a bad time.

Review your investment account and determine whether your holdings are diversified enough. Doing so might make your portfolio a dot of green in a sea of red when the next downturn comes around.

Haitham AlMhana is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of FINRA SIPC. All trades made by Haitham are placed through T3TG.

POSITION DISCLOSURE: Haitham AlMhana does not hold any long or short positions on AMZN, DJI, GSPC, LNT, or UNH as of the time of the publication of this article.

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