How many defensive shares should you hold?

If you’re a relatively defensive investor like me, you probably like to have a decent number of defensive shares in your portfolio.

But what number should that be? Or more correctly, what proportion of your portfolio should be invested in defensive shares?

One entirely reasonable answer would be to invest 100% of your portfolio in defensive shares. If you valued defensiveness and low risk above all else then that might be a good strategy.

But that could also be a bit restrictive as there are currently only 81 defensive companies in the FTSE All-Share out of a total of 626.

My approach to being defensive is a little more balanced. Yes, I want my portfolio to be less risky than the market, but I also want a market-beating dividend yield and market-beating capital gains as well.

In order to simultaneously achieve those three goals of low risk, high yield and high growth, I am willing to invest in cyclical companies because they can add a bit of rocket fuel to an otherwise dull portfolio. However, rocket fuel is dangerous stuff, so I wouldn’t want to overload on cyclical shares because they might explode during the next inevitable recession.

So what is the right balance between defensive and cyclical shares for an investor who wants to combine low risks with high yields and high growth?

An initial guess: At least 50% of a defensive portfolio should be in defensive shares

In 2014 I decided to start tracking my portfolio’s allocation to defensive shares. I also decided to set a minimum defensive allocation, in order to prevent the portfolio from becoming too cyclical.

My initial conclusion was that at least 50% of the portfolio should be in defensive shares, largely because a 50% minimum meant the portfolio would be more defensive than it was cyclical, which sounded about right.

To identify defensive shares I use the FTSE Industry Classification Benchmark “sub-sectors” (which I usually just refer to as sectors). You can find a company’s ICB sector on many investment data websites, such as the London Stock Exchange or SharePad.

You can find a list of these sectors on my stock screen, grouped as either defensive or cyclical (you’ll have to scroll down the page a bit).

Those defensive and cyclical definitions come from the Capita Dividend Monitor, which is a free quarterly newsletter and well worth a read.

If you want to work out your portfolio’s exposure to defensive shares, there are a couple of ways to do it:

• Count the number of holdings of each type (cyclical and defensive) and calculate each total as a percentage of your portfolio’s total number of holdings (e.g. 15 defensive holdings out of 30 would be a 50% defensive allocation), or
• Calculate the total capital value of each type and then calculate each as a percentage of your portfolio’s total value (e.g. £15k in defensive holdings in a £30k portfolio would be a 50% defensive allocation)

The first approach is simpler and I’ve used it in the past, but from now on I’m going to use the second approach as it’s more accurate and is still relatively easy to calculate (especially with a spreadsheet). If your holdings all have fairly similar position sizes then it won’t make much difference either way.

When I started tracking my defensive share allocation in 2014, the model portfolio just happened to be split about 50/50 between defensive and cyclical shares. No initial adjustments were necessary after I introduced the minimum 50% defensives rule, and currently, the portfolio is still bang on that same 50/50 split.

Here’s a chart showing how the portfolio looks today, viewed through the lens of its cyclical and defensive sector weightings:

As you can see, there’s a nice balance between cyclical and defensive sectors, with no one sector having more than 10% of the portfolio allocated to it.

However, recently it has been difficult to maintain a minimum 50% exposure to defensive shares, which has made me think that perhaps 50% in defensives is a bit excessive. And a 50% minimum could be especially restrictive in a bear market when many of the best bargains will be cyclical stocks.

But if a minimum target of 50% in defensive shares is not optimal (at least given my goals of low risk AND high yield AND high growth), what should it be?

As luck would have it, an insightful reader recently asked me more or less the same question, but in a different way:

How does your model portfolio’s target of being more than 50% invested in defensive shares compare to the FTSE 100, 250 and small-cap indices?

Of course! If the goal is to build a portfolio which can outperform the stock market but is also less risky than the stock market, then the stock market’s allocation to defensive shares is an appropriate benchmark; not a ballpark guess such as 50%.

So a few days ago I crunched the numbers and now I have a much better idea about how defensive the UK stock market is. I also have a new opinion about how much a portfolio should have in defensive shares before it can reasonably be described as defensive.

Let’s start with the FTSE 100.

The FTSE 100 has a high weighting to defensive shares

Intuitively I would have guessed that the FTSE 100 is the most defensive out of the UK’s large, medium and small-caps indices, and that intuition was correct.

Why? Because defensive companies operate in sectors such as electricity, telecoms and pharmaceuticals, and these sectors are well-suited to large companies. In fact, within the FTSE All-Share, the average market cap of defensive companies is £10 billion while the average market cap of cyclical companies is £3 billion.

So how defensive is the FTSE 100, the most defensive of the major UK stock market indices?

• Currently, the FTSE 100 has a defensive share weighting of 37%

(This figure excludes investment trusts, as do the figures for the FTSE 250 and Small-Cap indices)

Obviously, 37% is significantly less than my current target defensive share allocation of 50%, so it’s beginning to look like my 50% rule really is excessive.

Here’s another chart, this time showing the FTSE 100’s cyclical and defensive sector weights:

The FTSE 100 is clearly less defensive than my model portfolio and has almost 30% in total across two very cyclical sectors (banks and oil & gas producers).

However, as we’ll see it is still more defensive than the FTSE 250 or Small-Cap indices. I would probably say that the FTSE 100’s allocation to defensive shares is a reasonable minimum for a portfolio describing itself as defensive.

The FTSE 250 has a medium weighting to defensive shares

I thought the FTSE 250 would be less defensive than the FTSE 100, but I was surprised by how much less defensive it actually is. Here’s the headline number:

• Currently, the FTSE 250 has a defensive share weighting of 19%

A picture is worth a thousand words, so here are the FTSE 250’s cyclical and defensive sector weightings in more detail:

The lack of defensives is much more evident here, with sectors such as beverages and electricity having almost no exposure at all.

I think the FTSE 100’s 30-odd percent defensive allocation is minimal for a defensive portfolio, so I would definitely not call the FTSE 250 a defensive index.

The FTSE small-cap index has a low weighting to defensive shares

Moving down in size to the small-cap index also brings a further reduction in the proportion of defensive shares.

Here’s the headline result:

• Currently, the FTSE Small-Cap index has a defensive share weighting of 12%

And here’s the chart:

With just 12% in defensive shares and more than 20% allocated to a single sector (support services), I would describe the small-cap index as almost completely cyclical. The allocation to healthcare companies, the largest defensive sector in this index, is just 3%.

Having said that, I don’t think defensive investors should just automatically rule out investing in small caps. There are some good companies in there, although I would be surprised to see much more than a minimal small-cap allocation in most defensive portfolios.

How many defensive shares should you hold?

This is, of course, a subjective and personal question that only you can answer. However, I hope that some of this article will at least prompt you to think about the answer to this question.

Personally, given my goals of generating a higher income and higher growth from my portfolio as well as lower risk, I think my rule of having at least 50% in defensive shares is probably overkill.

Yes, I want my portfolio to be less risky than the overall market, but I’m not obsessed with defensiveness to the exclusion of everything else.

Also, I am willing to have a majority allocation to cyclical shares. That’s because the cyclical companies I invest in are likely to be significantly lower risk than the average cyclical company, thanks to my many investment rules.

With all that in mind, I have decided to tweak my defensive share rule of thumb to this:

• Always have at least 33% of the portfolio invested in defensive shares

Hopefully, that will be enough to maintain the portfolio’s record of being less risky than the market.

It should also give me the flexibility to load up on cyclical shares (to a controlled extent) when they’re far more attractively valued than their defensive counterparts, such as during the next bear market.