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

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.