Changing market conditions over the last five years have taught us a few things about managing risk. The most important lesson? Delivering downside protection constantly requires refining and adjustment.

Equity markets are never static. In recent years, equity investors have enjoyed handsome returns amid subdued volatility, yet market conditions have been far from simple. Interest rates have been stuck at historically low levels. The search for income has driven a flood of money into stocks with high dividend yields. Valuations have risen, particularly in the US. And political risk is a growing source of instability.

Always Think About Downside Protection

When markets are consistently rising, it’s easy to take risk management for granted. But in fact, we believe that the best time to think about risk is when volatility isn’t there so that your portfolio is properly prepared—waiting until turbulence strikes is often too late. In our experience, three broad lessons about risk management can help underpin a portfolio strategy for downside protection.

• Define risk more broadly—Traditionally, many investors have used tracking error to gauge portfolio risk. But tracking error, which measures the deviation of performance of a portfolio or stock from the benchmark, is an unsophisticated, one-dimensional measure. In a volatile or down market, closely tracking the benchmark offers little solace.
  
  Similarly, investors often think of low beta, or market sensitivity, as a sign that a stock or portfolio is less risky than the market. This, too, is relative, and under some conditions beta can prove to be a poor predictor of returns. For example, if you’re paying a lot for a low-beta stock that’s highly sensitive to interest rates, it may be riskier than you think.
  
  Standard deviation does a better job of measuring absolute risk, but doesn’t really help deliver a desired investment outcome that’s enough to meet investors’ needs. So it’s important to broaden a definition of risk by thinking about upside and downside capture, or how much your portfolio will capture market moves on the way up and down, as a fundamental component of investing strategy. After all, for many investors, risk is all about reducing losses when the market is falling. And investors are prone to emotional biases that can lead to poor decisions, like selling after a big loss. Focusing on delivering a smoother pattern of returns can yield more wealth and a more satisfying outcome.
• Defense is dynamic—In investing as in sports, defensive formations must change along with circumstances. A defensive strategy that worked well yesterday may not work tomorrow in a different market under different conditions.
  
  Utilities and telecom stocks have been considered defensive plays for a long time. But that could change if interest rates (finally) rise. Are all consumer-staples stocks as safe as they seem? Not necessarily, if an Amazon-induced earthquake rattles the retail sector and small upstarts build viable new brands through non-traditional media. Combined with their relatively high valuations, these traditional defensive hideouts may not prove so safe.
  
  On the flip side, 20 years ago, many investors thought energy stocks were safe havens. And large-cap tech names, especially in enterprise software, have become some of the most stable cash-flow generators. How times have changed.
  
  The lesson is simple. When devising a defense, don’t rely on an old playbook. Look carefully at current market behaviors, sensitivities and new forces of change that could redefine the essence of safety.
• Stable companies come in many forms—Don’t be locked into preconceived notions of how to source stability. It’s not just about investing in certain sectors (like utilities and staples) or certain equity factors (like low beta).
  
  Finding stability requires a more sophisticated approach. Look for high quality businesses with less market or economic sensitivity. These exist across the market, but require hard work to find. Some are companies that are positioned to benefit from long-term secular changes in their industries. Proven cost benefits or other competitive advantages are another source of stability. Still others might operate in markets with structural advantages or favorable regulatory conditions. We’ve found companies that offer degrees of stability in industries ranging from technology to industrials to financials, which aren’t typically places that investors search for safety.

Following these three principles can help form the backbone of an equity strategy that loses less in market downturns and can recover more quickly in a rebound. Whether markets are volatile or not, we believe that investors should always be prepared to change direction in deploying downside protection—because market risks never stand still.

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.