How to invest defensively amid volatility
Risks are now appearing from a more varied range of sources
THE nature of risk has changed. Before the pandemic, a slowdown in growth was the chief worry for investors. When it looked like economic prospects were turning sour, it made sense to turn to bonds and sectors that could deliver reliable earnings even in a recession, such as consumer staples, utilities and healthcare. Investors often reflexively reduced active risk from security selection and tactical asset allocation too.
Shifting geopolitics means that today’s world is more fragmented. Risks are now appearing from a more varied range of sources. Investors now need to keep an eye on growth, inflation and conflicts, among other things, from artificial intelligence (AI), and the concentration of global equity indices in US tech, to name but a few.
At the same time, bonds have become more volatile and positively correlated with equities, reducing their effectiveness at cushioning multi-asset portfolios at times when equities come under pressure. Inflation has also posed problems for some “defensive” equity sectors, such as consumer staples, while the healthcare sector’s future has been clouded recently by uncertain US policy.
Adding all this up, it is clear that we are now in a world where investors need to look beyond the traditional “defensive” assets and use a broader tool kit in order to protect their portfolios.
There are two key elements to our approach to being defensive in the current environment – adequate diversification and avoiding overcrowded trades.
A different way to think about diversification
Diversification is the first essential piece of the puzzle. But we do not just mean holding a global equity index and a global bond aggregate index in a portfolio. To us, diversification means building a portfolio that can perform well in a range of different macroeconomic scenarios.
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By building a portfolio that is able to cope with a range of different economic and geopolitical scenarios – rather than just the most probable – investors can reduce the chance of getting caught off guard when conditions change, and enjoy a smoother outcome as a result.
For example, we currently hold a sizeable portion of our investments in assets that should perform well in typical “risk-on” markets. However, we also hold put options that may offer protection if we enter a risk-off environment.
In addition, we have some long-maturity bonds that should provide ballast in the event that falling growth becomes a more pressing concern than inflation. But we also hold positions in gold and other commodities and inflation-linked bonds that have the potential to help performance if growth slows but inflation rises.
Increasing diversification by allocating to a broader range of assets, especially those that are less correlated to equities and bonds is also important. We currently have allocations to market neutral equity strategies, tradable carbon emissions and catastrophe bonds; but investors could also consider other assets with idiosyncratic drivers of return where appropriate.
Avoid the crowds
The second vital element to being defensive today is avoiding overcrowded areas of the market. There are always particular themes that have their moment in the limelight, when it can seem like the whole world is invested in the same idea. In the 2010s it was US tech, while today it is AI.
While these trades can certainly be profitable for a while, relying too heavily on consensus ideas leaves you open to sharp and often unpredictable swings in sentiment irrespective of fundamentals.
To mitigate this risk, we prefer to look for less-frequented areas of the market. There are several sectors and regions that do not enjoy the spotlight but have achieved double-digit performance this year – Eastern Europe, Latin America, nuclear, European defence, European banks, some emerging bond markets and so on.
These less crowded areas of the market tend to follow their fundamentals to a greater extent – meaning good research pays off, and investors are less at the mercy of unpredictable sentiment swings working in their favour.
Being defensive today means thinking differently about the future
The traditional playbook of bonds, defensive equity sectors, or the US dollar may still have a role, but it is no longer sufficient in 2025. In today’s fragmented and more volatile world, being defensive means embracing diversification in its fullest sense, not just across asset classes but across macroeconomic scenarios. It means avoiding overcrowded trades and seeking out less-travelled paths where fundamentals matter more than momentum.
We do not believe this is a time to reduce active risk. The environment of higher volatility, greater fragmentation and elevated dispersion that we find ourselves in is better suited to a dynamic and nimble approach to asset selection.
By leaning into active risk, allocating with intent and staying agile, investors can build portfolios that are not only prepared for the surprises of 2025 and beyond, but able to thrive in them too.
The writer is portfolio manager, Fidelity International
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