The Virgin Investor quickly discovers that not all shares perform equally, and that there are many different variables affecting the price of a share. For example, company shares are affected by the political and economic policy of the countries it operates in, the outlook for the industry it operates in, and company performance/expectation at the release of quarterly results (amongst many other variables). A large part of managing a share portfolio is to manage the risk of the portfolio as a whole, and this can be done by stepping out of the detail and taking a top down approach.

At the highest level this means beginning by diversifying a portfolio between a number of different asset classes – equities (stocks), bonds and cash may work as a starting point. Then within each of these asset classes, further diversification should take place. Within equities, a key decision is to decide the balance of the portfolio between defensive and cyclical stocks.

 

Defensive Stocks

Shares that have low correlation to economic activity and sentiment. An example would be pharmaceutical and tobacco stocks – industries where consumer spending tends to take place at a stable rate regardless of economic cycles.

Examples on the FTSE 100: GlaxoSmithKline (pharmaceuticals) and Imperial Brands (tobacco).

 

Cyclical Stocks

Shares that are highly correlated to economic activity and sentiment. A consumer example would be a leisure, as in improving economic times, people are more inclined to spend on non-essential leisure experiences. A business example would be an IT infrastructure company,  as in improving economic times, businesses are more inclined to spend money on IT infrastructure projects whereas in a downturn , this type of spend is likely to get delayed.

Examples on the FTSE 100: Burberry (fashion) and Experian (information technology).

 

Grey Areas

Sometimes traditional defensive stocks will correlate more strongly than expected with the economic cycle and traditional cyclical stocks will correlate more weakly than expected with the economic cycle.

For example a fashion retailer like Burberry may traditionally have been viewed as a cyclical stock dependent on consumer economic confidence and disposable income. However, recently luxury goods companies have increasingly displayed defensive qualities due to the strength of the brand effectively maintaining consumer spend.

 

To conclude

As a general rule, defensive stocks offer more stability and so carry lower risk than cyclical stocks. However, bought at the right time, the returns from cyclical stocks could be higher.

Using economic data to build up an understanding of economic cycles will leave The Virgin Investor in a good position to shift the balance of an equity portfolio between defensive and cyclical stocks to maximise returns. Pairing this top down approach with a good bottom up understanding of the companies being invested in, will give the greatest chance of investment success.

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