Don’t Lose Your Nerve: Four Ways to Reduce Equity Risk

13 July 2022
4 min read

Equity investors are anxious about the future after sharp market declines in the first half of 2022. These four guidelines can help investors frame a defensive strategy for volatile times and bolster confidence to stay in equities through an uncertain period ahead.

1. Develop a Dynamic Defense

Every downturn is different, so the defensive script must change accordingly. What’s different this time? The world is experiencing a two-step correction. One is a revaluation of stocks that became very expensive, particularly among hypergrowth companies. It’s reminiscent of 2000, when the dot-com bubble burst, deflating excessive valuations of companies with little to no profits. This is a healthy process. The second, and trickier, risk is tied to economic sensitivity. As companies adjust to inflation, rising interest rates and a likely economic slowdown, investors are struggling to compute future earnings and the impact on stock valuations.

Both developments differ from the COVID-19 crash of early 2020, the brief increase in interest rates in 2018 and the challenges created by the US-China trade war.

When devising a defensive strategy, old playbooks may be obsolete. Consider current market behaviors, sensitivities and new forces of change that could redefine the essence of safety.

2. Cast a Wider Net for Stable Companies

Preconceived notions of how to source stability can be restrictive. Companies such as utilities, consumer staples and healthcare have typically provided stability in volatile markets. And it’s true that these sectors have performed relatively well so far in this year’s market downturn and should form part of any defensive portfolio.

But broadening the sources of stability can help diversify risk and return potential. Look for high-quality companies with less market or economic sensitivity. These can often be found in business models that underpin consistent cash flows, even when many businesses are getting squeezed by macroeconomic conditions. Some are companies positioned to benefit from long-term secular changes in their industries. Proven cost benefits or other competitive advantages are another source of stability. Intangible assets, from R&D to human capital to brands, also help support earnings in times of stress. We’ve found companies like these in industries ranging from industrials to technology, which aren’t typically places that investors search for safety.

Technology enablers are a good example. These are the utilities of the technology world because they help ensure that our networking infrastructure and business processes run smoothly. Like traditional power and water utilities, they’ve become essential components of a functioning economy, so their products and services are likely to remain in demand even in a tougher economy. Resilient business features like these often translate into share prices that can withstand market stress.

3. Steer Clear of Unpredictable Forces

Geopolitical risk and macroeconomic developments simply cannot be predicted with certainty. So it’s not prudent to take a directional bet on them as part of a defensive equity investing strategy.

For example, some investors might consider building a strategy on the direction of interest rates, which do affect stock valuations. Clearly, interest rates are rising in the US, Europe and other major economies. But nobody can say how fast they will increase, where they will level off or at what point they will fall.

Energy stocks are another case in point. It might seem tempting to pile into shares of oil and gas producers, the only sector that generated gains in the first half of 2022. But energy stocks are driven primarily by oil and gas prices, which are extremely erratic because they are determined by geopolitical events and decisions. The direction of energy prices—and stocks—can change dramatically overnight.

The war in Ukraine, election results and regulatory action are other examples of risks that can’t be forecast. Of course, these events have a big impact on companies and markets. So when researching a stock, investors should assess how significant the business’s exposure is to an unpredictable risk—and get out of the way of things that can’t be controlled.

4. Don’t Lose Your Nerve

When markets are falling and turbulent, it’s easy to lose your nerve. Even the best-planned strategy may feel flimsy when losses are mounting.

But selling equity positions in a falling market means locking in losses and forfeiting recovery potential. And since it’s almost impossible to time market inflection points, investors who sell risk missing the best days of a rebound, which can impair long-term returns dramatically.

Lower-volatility equity strategies can help reduce risk and make it easier to stay in equities. But it requires clear parameters and processes for finding companies that can weather tough environments, along with an open mind that is flexible to the changing conditions driving markets. Sticking with a disciplined investing philosophy can widen an investor's comfort zone and help maintain exposure to equities through a downturn in order to benefit from a future recovery.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

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