Some stocks do better during downturns than others. Investors depend on these stocks to protect them from the full damage of market crashes. So in light of yesterday's 635-point decline for the Dow, it's a reasonable time to ask a simple question: Are the stocks that investors believe can defend your portfolio from bad markets getting the job done?
What's behind defensive stocks
The rationale as to why some stocks don't fall as much during market downturns is pretty simple. During wild bull markets, exciting stocks with fast growth rates and lots of future potential draw most of the attention from investors. That's because when stocks are going up, these stocks tend to go up faster, bringing better overall returns to those willing to take some extra risk.
On the other hand, dull, boring stocks with minimal growth prospects and stable businesses don't have much flash during bull markets. But when the economy slows, they have what it takes to get through the tough times with less of an impact on their business -- and therefore their stock price -- than those flashier high-growth investments.
Some of the industries that investors tend to see as defensive include health-care stocks and consumer staples. The reason is simple: When the economy is bad, people may be able to put off big-ticket consumer items, and industrial activity may slow down enough to hurt cyclical industries. But everyone still needs the medical care and basic products they use every day, and so the companies that sell them have a built-in buffer against a slowing economy.
So, are they working?
So far, it looks like at least some defensive stocks are succeeding in limiting investor losses. That's especially apparent in consumer staples. Johnson & Johnson (NYSE: JNJ ) and Procter & Gamble (NYSE: PG ) had the smallest losses in the Dow Industrials yesterday, falling just over 2% versus the Dow's 5.5% drop. Similarly, Coca-Cola (NYSE: KO ) and Kraft Foods (NYSE: KFT ) , which sell the food and beverages that people need, lost between 3% and 4%.
Health-care stocks, on the other hand, didn't do quite as well as some would have hoped. Both Pfizer (NYSE: PFE ) and Merck (NYSE: MRK ) lost almost as much ground as the entire Dow. After a big run during the first half of the year, it's possible that investors figured that it was time for them to correct downward as well. And beyond the Dow, concerns about how health-care plan managers like WellPoint (NYSE: WLP ) could be left holding the bag for lower reimbursement rates on Medicare have weighed down the sector since the debt ceiling bill passed.
Should you buy defensive stocks?
So if stocks in defensive industries do such a good job, does it make sense to load up on them in your portfolio? Unfortunately, there's a trade-off for the downside protection that defensive stocks provide: They aren't typically very strong performers in bull markets.
For instance, take a look at J&J. The stock dropped just 8% during 2008, a year in which the S&P 500 fell 37%. But when you look at the following year, J&J rose only 11%, quite a bit less than the S&P's 26% gain. You'll see similar patterns of performance from P&G and Kraft.
Despite their shortcomings, though, defensive stocks can put in nice returns over the long haul. Moreover, their reduced volatility makes them the sort of stocks that you don't have to pay constant attention to.
Defensive stocks shouldn't be the only stocks you own. Especially if you're young and have decades to go before you reach retirement, having stocks with better long-term growth prospects is worth the risk.
But if you're a conservative investor or you're relatively close to retirement, defensive stocks can give you a great middle ground, letting you keep some stock exposure while somewhat protecting you from the volatility that can threaten your financial future.
Learn more about big threats to your wealth in this video from The Motley Fool. Not only will it tell you how to protect yourself, but you'll also get a stock choice that has great potential even in a down market.