For Better or Worse: Navigating Potential Volatility in 2026

For Better or Worse: Navigating Potential Volatility in 2026

Equity market hedging strategies are one of several tactics that investors should consider if conditions impacting stocks grow more hazardous, says Bill DeRoche AGF Investments’ head of quantitative investing.  

What is your outlook for U.S. equity markets in 2026?

Based on what our quantitative models are telling us right now, we are quite constructive on what lies ahead in 2026. In particular, we believe there is a high potential for earnings growth and a lower discount rate [the minimum rate of return expected to be earned on an investment given its specific risk profile], both of which bode well for equity markets next year.

That’s not to say there aren’t risks to this forecast. For instance, if earnings growth is to reach its potential, we likely need to start seeing more return on investment (ROI) from companies involved in building artificial intelligence (AI) innovations and the infrastructure needed to support it. There has been a tremendous amount of capital expenditure on this front, but the payoff as of now may not be enough to keep supporting the already tremendous rise in share prices associated with the AI trade. Still, when I see and hear from businesses about some of the productivity gains being derived from AI, it gives me confidence this ROI will come to fruition, even if it means more turbulence in equity markets along the way.

How does the almost unabated rally in equity markets since the end of April temper your expectations, if at all?

It’s very rare for equity markets to climb without much interruption, so we always want to understand what potential risks are out there, even when the expectation is generally positive. We like to think of this mindset in terms of hazards, which I’ll explain using an analogy from one of my colleagues.

Say you’re walking down the street on a beautiful, sunny afternoon. In this scenario, the probability of you tripping and falling is low, and I would describe equity markets as being like that earlier this year, in the spring, at least once President [Donald] Trump backed down from fully implementing his Liberation Day tariffs. At that time, the U.S. equity market was fairly valued, but after such a strong rally through the summer and early fall, we view it as being slightly overvalued, particularly in consideration of emerging hazards such as a weakening labour market in the U.S. In other words, it’s now like walking down the street at night and the sidewalks might be getting icy. We believe the conditions are much more hazardous and the chance of you falling is increased.

Given your cautious optimism about 2026, what is your investment approach for balancing potential opportunities with potential risks in the new year?

We like to think in terms of wealth maximization and consider mathematical models around that, including the Kelly Criterion, which helps calculate how much to invest in a single trade based on a winning probability. Said differently, it’s about sizing our ‘bets.’  So, yes, we’re constructive on the U.S. equity market in 2026 and we want to be invested in it, but as we identify more risks on the horizon, we’ll want to be a bit more cautious, which means modestly reducing our exposure. And by doing that consistently in response to emerging hazards, we find we’re able to maximize wealth more effectively.

Of course, there’s no one-size-fits-all to this approach. It’s very different for a professional money manager like us as opposed to an individual investor who needs to consider their investment objectives, overall risk aversion and investing timeline. If you’re close to retirement, for instance, chances are you’re going to be a bit more conservative about your exposure to equity markets, but even more so when volatility is heightened.

To that end, how important is it to allocate assets both strategically and tactically as the need arises?

It should be no surprise that we view both aspects of asset allocation as critical to managing risk, but they do serve different purposes. A strategic allocation may pertain more to different stages in someone’s investment life cycle. For instance, as I alluded to earlier, a younger person just starting to invest and build wealth can generally withstand more risk than someone closer to retirement because they have time for their investment to recoup any losses that may occur in the short term. As such, they may have more exposure to equities than their older counterpart who, as they have moved through their life investing cycle, have dialed down their strategic risk allocation by reducing their overall equity exposure from what it was earlier in the cycle.    

A tactical allocation, meanwhile, is more akin to what we were discussing in the context of market hazards. Think of it as an overlay to someone’s strategic allocation that accounts for shorter-term risks by reducing exposure to a certain type of investment on a more temporary basis. Again, this is about bet sizing, and there are different ways to do that. These include selling out of some core equity positions and raising cash, but may also include the use of equity market hedging strategies that may help limit downside risks, while also capturing upside potential.

What do investors need to consider when choosing between raising cash or using a hedging strategy to reduce market exposure?

Both can effectively reduce market exposure, but cash may be less efficient as compared to a hedging asset that is negatively correlated with equities. In other words, to gain the same effect, investors will usually need to raise more cash than they would generally need to allocate to a hedging instrument. Ultimately, we believe 2026 should be another good year for equity markets, but not having a plan for mitigating risks that may arise could be hazardous to some investors’ wealth, should they choose to ignore them.