What are cyclical versus defensive shares?

Companies can be classified by their size or their industry, but also by the types of factors that influence their share prices.

You’ll read a lot about the need to have a diversified portfolio of investments, spread across a range of asset classes like shares, bonds and property.

But it’s equally important to diversify within an asset class like shares to ensure you are exposed to companies that react differently to changes in the wider economy.

Getting to know the different categories of shares in this context can help you increase your level of diversification.

Cyclical shares

These are companies whose earnings, profit and share prices tend to be aligned to the fortunes of the wider economy.

Cyclical shares will benefit from strong economic growth but suffer when economic growth is slowing or even contracting.

Examples include property companies and retailers of discretionary goods that see revenue rise when the economy is on the up and when people have more disposable income.

Countercyclical shares

These are companies whose shares tend to move in the opposite direction to the broader economy and cyclical shares.

They have the potential to prosper from an economic downturn by offering goods or services that people spend their money on during times disposable income may be sparse.

Examples of countercyclical shares could include gold mining companies, credit collection firms or discount retailers.

Defensive shares

These are companies that are broadly protected from downturns in the economy and the associated decline in consumer and business spending because they supply goods or services that are considered necessities.

Examples include healthcare, telecoms and utilities because although you might look for a cheaper alternative when the economy is struggling, you would not be able to do without them altogether.

Interest sensitive shares

These are companies whose shares are affected by changing interest rates, whether they are moving up or down.

The share prices of financial services companies including banks and asset managers can be sensitive to interest rates.

Bank profits depend on large amounts of borrowing and when interest rates are low, demand for business loans or mortgages would be expected to grow, for example.

As interest rates rise, demand for loans could decline due to the higher cost of servicing them.

Home builders are another example, because when interest rates are lower, the demand for new houses can rise and vice versa.