How to Capture AI Innovation in a Risk-Aware Equity Portfolio

Technological disruption creates opportunity—and volatility. But there are ways to capture AI innovation while managing risk.

Companies at the heart of the AI revolution are widely seen as expensive, fast-growing businesses that wouldn’t usually be held in a defensive portfolio. Yet we think select firms within the AI ecosystem can fit into a risk-aware equity allocation that has an eye on quality sources of long-term growth and a thoughtful portfolio construction strategy.

Investors seeking to reduce risk in equity allocations often lean into traditional defensive sectors, such as utilities or consumer staples. However, we think investors should cast a wider net to create an equity portfolio aimed at delivering more consistent return patterns through both down and up markets. Technology stocks can play an important role in that mix, so long as the portfolio manager focuses on companies with profitable, sustainable business models.

The Market Dynamics of Transformational Technology

AI is perhaps the most transformational technology cycle since the birth of the internet. Yet we’re only in the initial phase of testing and experimenting with commercial applications. And it’s easy to lose sight of the technology sector’s breadth when the spotlight is on a narrow group of mega-cap stocks.

The potential for AI to unlock efficiency across industries has triggered spectacular gains for the companies enabling the disruption. Since late 2022, when ChatGPT was launched, the Magnificent Seven stocks have dominated market returns because of their prominent role in developing the hardware and building the infrastructure for generative AI (GAI). As a result, some of these stocks now have high valuations and are vulnerable to volatility. The growth opportunities are real, but so are the risks—especially if you’re wary of expensive equity price tags.

So is there a way to incorporate AI-driven stocks in an equity allocation focused on risk reduction? We think so. The key is to look for companies with high-quality business models, a degree of stability and relatively attractive valuations for the sector, even if they may be somewhat pricier than the broad market average. Like other companies in a defensive allocation, the AI businesses we favor have strong profitability, measured by return on assets (ROA) and return on invested capital, which are robust predictors of future earnings power. Capital discipline is another feature that can help support margins, particularly in a world of higher interest rates.