Defense and Discipline: How to Stay Calm in Unruly Equity Markets

A well-planned defensive strategy can position equity portfolios to be resilient in a very harsh market environment.

Volatile equity market conditions are testing even the most experienced investors. Deploying strategic defensive investing principles can help steer portfolios through extreme uncertainty.

President Donald Trump’s oft-changing tariff agenda has made it hard for companies and investors to forecast earnings. Meanwhile, the Magnificent Seven’s domination of equity markets appears to be waning. As a result, the range of outcomes for companies has widened dramatically amid fears of an economic slowdown or recession, while equity market returns may be poised to broaden and diverge regionally.

Investors understandably feel anxious. But reducing equity exposure can be counterproductive. Our challenge as defensive equity portfolio managers is to help investors gain confidence to stay in stocks for the long term.

Volatility Is a Round Trip

Start by remembering that volatility goes in both directions—down and up.

Indeed, investors who reduced equity exposure when US markets tumbled by 12% in the days after Trump’s April 2 tariff announcement would have locked in losses and sacrificed gains from the market rebound a week later. It’s nearly impossible to time market inflection points at the best of times, let alone when markets are being driven by unpredictable policy moves.

Moments of extreme fear are often followed by strong equity rebounds. Our research shows that when the VIX, an index of US equity market volatility, reached extreme levels during the most severe market crises since 2000, returns for the S&P 500 and the MSCI World averaged 34.4% and 37.4%, respectively, over the next 12 months.

While we don’t know how the current trade war will play out, we believe staying in the market offers investors the best chance to capture strong long-term equity return potential.

Reducing Losses in Down Markets Is Essential

Of course, it’s easy to lose faith in a strategic plan in turbulent markets. But if worst-case scenarios don’t materialize, equity returns often turn out better than expected.

So how can investors avoid succumbing to risk aversion? We think the key is to build a portfolio that aims to create smoother return patterns through volatile markets. The goal: to reduce the pain of absolute losses when markets fall while capturing most (but not all) of the market’s gains through a recovery. When a portfolio loses less on the way down, it has much less ground to cover to recoup losses. Our research suggests that a strategy that seeks to capture 90% of market gains but only 70% of losses can even generate outperformance versus the broad market over the long term (Display). 

Many investors focus on the relative risk of a portfolio versus a benchmark. But we think a shift in focus to absolute risk—mitigating downside risk—can help offset loss-aversion, which shapes investor psychology and often leads to bad decisions when fear sets in. And taking no risk is just as risky as taking too much risk, because you forfeit recovery potential.

Stay Focused on Fundamentals—Even in a Trade War

Yet striking a balanced risk/reward profile is especially difficult today. Developing conviction in earnings forecasts and a stock’s return potential requires a degree of certainty about the future. For us, evaluating fundamentals is the bedrock of risk-aware equity investing and a defensive strategy targeting high-quality businesses with strong cash-flow generation. But how can we develop a clear view of quality when tariff policies that can instantly undermine business plans are constantly changing?

We’re using a fundamental framework to evaluate the impact of tariffs on a company-by-company basis (Display). It has three components: estimating the exposure of a company’s revenues and inputs to different types of tariffs; evaluating the direct impact of tariffs on profitability, which often depends on a company’s pricing power; and considering the indirect impact of tariffs on a business, such as the effects of economic cycles or higher inflation.

This framework is one component of a broader research effort—including quantitative artificial intelligence (AI) tools— to scour the market for high-quality businesses backed by healthy balance sheets and skilled management teams. Shares of quality companies with stable trading patterns and attractive prices—what we call QSP—can form a solid defensive foundation for evolving challenges. These days, some of these companies can be found at especially attractive valuations, which augments their recovery potential.

Valuation Matters as Concentrated Markets Unwind

Focusing on valuations is always important for investors. But it didn’t feel that way in recent years as the relatively expensive Magnificent Seven stocks rose to dizzying heights on enthusiasm for AI. While the mega-caps include great businesses, we believe equity portfolios should hold individual names based on their investing philosophies and at appropriate weights.

In concentrated markets, many investors ended up tilted toward the largest stocks, sometimes unintentionally. Portfolios that avoided or de-emphasized the mega-caps paid a penalty, even if underweight positions were backed by research conviction and were in line with an investment mandate.

Since DeepSeek’s AI breakthrough jolted the mega-caps in January, we’ve seen a divergence in the Mag Seven’s performance. Across the sector, valuations of AI-related stocks have come down significantly, while volatility has increased—in part because of the risk that more efficient use of chips will reduce demand for semiconductors. Broadening market returns within and beyond the US mega-cap stocks reminds us that investors who follow crowded trades could get hurt if concentrated markets unwind further.

Developing Defensive Diversification

The concepts above can help create effective defensive diversification in several ways.

First, following these guidelines should pull defensive portfolios toward services-oriented companies rather than goods producers, which are more susceptible to tariffs. For example, internet-based travel services and select financial-services firms simply aren’t in the direct line of fire of the trade war.

Second, defensive diversification requires a selective approach to technology. Software companies are less vulnerable to tariffs and offer opportunities to capture AI innovation in a risk-aware portfolio. Semiconductor and hardware companies are far more vulnerable to tariff risks and are a less defensive allocation, in our view.

Third, even in sectors that seem susceptible to tariffs, search for exceptions. Often, these companies trade at relatively attractive valuations because of perceived risks. Examples include industrial companies with operations primarily in the US, digital publishers or engineering groups that benefit from megatrends like global infrastructure spending.

Finally, regional diversification deserves attention in global allocations. Trade wars will have a global impact, but US companies are still relatively pricey and more vulnerable to tariffs, while European and Asian markets offer relatively attractive valuations. During the first quarter, European stocks outperformed, reminding us of the benefits of regional diversification.

The ever-changing landscape of global trade underscores the need for a disciplined investing approach that is attuned to changing market dynamics. For defensive investing to succeed in these unpredictable times, investors should resist the temptation to react impulsively to market movements while drawing on strategic investing lessons learned from past market crises.