Portfolio diversification is incredibly essential for any good investor. Having a balanced portfolio offers a wider scope for returns and also helps minimize the blow of a loss. One way of creating this balance is by putting some thought into stock selection. Stocks can be classified on the basis of different parameters, depending on what needs an investor is looking to address. When it comes to the intrinsic nature of stocks, they can be categorized as cyclical and non-cyclical stocks on the basis of the relationship between the share price and movements in the economy. It is important for any investor, new or experienced, to understand the distinction between the two types in order to be able to make informed decisions about their investments.
What are Cyclical and Non-Cyclical Stocks?
‘Cyclical’ and ‘non-cyclical’ are terms that refer to the extent of correlation between the share price of a company and the changes in the economy. Cyclical stocks have a direct relationship with the economy. Non-cyclical stocks have an inverse relationship in the sense that when economic growth is slower, these stocks perform better than the market. Let us understand these two types in detail.
- Cyclical companies tend to directly follow the overall economic trends, thus their share prices are quite volatile.
- Cyclical stock prices go up with economic growth and drop with a downturn in the economy. Similarly, these stocks follow economic cycles such as peak, expansion, recession and recovery too.
- Companies that offer discretionary/dispensable goods and services that are in demand during a period of economic growth have cyclical stocks. Businesses like airlines, travel companies, restaurants, hotels, automobile manufacturers, etc. fall under this category.
- These are businesses that are cut first when the economy hits a rough patch. In tough times, the demand for their businesses reduces drastically, forcing their stock prices to drop. If this is prolonged, these businesses may even have to shut shop.
- Just as it is hard to predict the fluctuations in the economy, the performance of cyclical stocksis also tricky to predict, thus making it an unstable opportunity for investors.
- Non-cyclical stocksare those that tend to outperform others in a time of economic slowdown.
- These stocks represent companies that provide necessary goods and services that are always going to be in demand. These goods and services include gas, electricity, water, food, etc.
- Since the demand remains fairly consistent regardless of economic changes, these stocks also generally remain profitable.
- These stocks are also referred to as defensive stocks since they put up a good defence against economic downturns and protect investors. These are reliable investment options in times when economic progress has stalled.
- Non-durable, essential household products like soap, toothpaste, shampoo, etc. Also, count as non-cyclical goods as people will always consistently need them. Electricity is another major example. These are goods and services that are indispensable, thereby ensuring that the companies providing are always kept in business and can grow steadily without extreme fluctuations.
- Hence, while non-cyclical stock prices may not shoot up in times of economic growth, they still provide security and stability.
- Non-cyclical stocksare a great investment for investors with low-risk tolerance who wish to avoid losses during dire economic circumstances.
Cyclical vs Non-Cyclical stocks
Let us take a look at how cyclical vs non-cyclical stocks are different from each other:
Correlation with the economy
Cyclical stocksdepend heavily on the economic conditions; non-cyclical stocks do not. Non-cyclical companies/industries operate independently, regardless of an economic slump or growth. Essential products and services are constantly in demand, and the demand stays the same even during economic downturns.
Non-cyclical stocks are stable and constant; cyclical stocks are much more volatile in comparison since they are influenced by consumer demand. Hence, non-cyclical stocks are referred to as defensive stocks and cyclical stocks are called offensive stocks.
Potential returns and risk
Although cyclical stocks involve higher risk, the potential returns during a period of the economic boom could be quite substantial. With enough knowledge and good timing, investors can trade cyclical stocks for a considerable profit. Meanwhile, non-cyclical stocks offer stable returns and involve less risk. They can also protect investors from losses during an economic slump.
For any investor, a base understanding of how companies and industries operate in the economy is necessary. There are certain fundamental distinctions between companies that are affected by changes in the economy and those that are relatively resilient against them. Cyclical stocks are from companies that provide dispensable or luxury goods and services: restaurants, high-end clothing stores, automobile manufacturers, airlines, etc. Non-cyclical industries provide essential goods that are necessities in our daily lives: electricity, water, hygiene products, etc.
The ebb and flow of the economy are not in the hands of investors; however, they can work around it and even use market fluctuations to their advantage.
Cyclical stocks and non-cyclical stocks each have their own features, advantages and pitfalls. During unexpected world events such as the Covid-19 pandemic, economic upheavals can leave a huge impact on the stock market. With a view to this, it is vital that investors diversify their portfolios. Make sure to assess your stock options, the market direction, your risk tolerance and investment goals carefully, so you can manage your investments in a way that protects your money while bringing in the returns you desire. Researching market trends, stocks, sectors and companies thoroughly can help you prepare for different economic circumstances. Thus, having a strong foundation of knowledge about economic cycles and types of stocks will empower you, as an investor, to make the most of your opportunities in the market.