Mastering the basics of investing can be a pretty tricky business.
That includes investing in shares, which often comes with a long list of share market terms and concepts to get your head around.
One idea that’s particularly important to get a handle on when you’re starting out is the difference between cyclical and non-cyclical shares.
That’s because a good understanding of these two types of shares will get you better equipped to build an investment portfolio that’s in line with your appetite for share market risk.
In a nutshell
Don’t worry, you don’t have to be a share market guru to get across the basics.
Simply put, the difference between a cyclical share and a non-cyclical share is that rises and falls of cyclical shares usually correlate with how the economy is going, while non-cyclical shares are usually not impacted by how the economy is going and so tend to be less volatile.
For that reason, as you’d expect, cyclical shares usually represent goods and services that are purchased more strongly when confidence in the economy is high.
By contrast, non-cyclical shares tend to represent goods and services for which demand stays relatively constant, no matter if the economy is strong or weak.
An easy way to get your head around whether a stock is cyclical or non-cyclical can be to look at things sector-by-sector.
For instance, Morningstar classifies shares into 11 sectors. Four of the sectors (basic materials, consumer cyclical, financial services and real estate) are cyclical shares. While others (such as healthcare and utilities (e.g. gas and electricity) are non-cyclical.
Non-cyclical shares
The big thing with non-cyclical shares, sometimes known as defensive shares, is that they are shares in companies that generally hold up well during downturns in the economy.
Demand for these companies’ essential products and services is sometimes known as being “sticky” because it sticks around, irrespective of the health of the economy.
Another way to think of it is that while you may seek out a cheaper alternative in tough times, you can’t do without these products or services altogether.
Non-cyclical industries include healthcare, telecommunications and utilities like water, electricity and gas.
A few examples of non-cyclical ASX-listed stocks are Sydney Airport Holdings Pty Ltd, Transurban Group, ASX Ltd, Wesfarmers, Telstra and Cochlear.
Cyclical shares
As touched on, cyclical shares are shares in companies whose earnings, profit and share prices tend to be more aligned to the fortunes of the broader economy.
During economic upswings, these companies can benefit from strong economic growth as consumers splash out on inessential items. But during economic downturns, these companies generally suffer when consumers close their wallets and focus on essentials.
For a novice investor, it may seem like a smart move to buy cyclical stocks at the start of an economic boomtime and then to sell them just before a downturn kicks in. But be careful --it it's virtually impossible to time when such a downswing will happen.
Cyclical industries include resources, energy, financial services, real estate and discretionary retailers that benefit from consumers having more disposable income.
Some examples of cyclical stocks listed on the ASX include Caltex, IAG, Steadfast, Corporate Travel Management, Qube and Suncorp.
Bottom line
A balanced portfolio will have both defensive and cyclical shares, but the balance largely depends on your personal circumstances, market view, requirement for dividends and your tolerance for risk.
If you have a high tolerance for risk, you may skew towards cyclical stocks to take advantages of growth opportunities in a boom market.
However, if your tolerance for risk is lower, you may prefer to be concentrated in non-cyclical shares as they are less volatile and business-cycle dependant.
Remember, while buying shares is exciting, it is not without risk. Always consider your options carefully before you enter the market and make sure to get financial advice.
