It’s been over a year now since we first heard news reports of a respiratory virus spreading through China. Months later, the COVID-19 pandemic continues in the U.S. and its impact on Main Street remains noticeable every time you look around your neighborhood. While the extreme volatility we saw in February and March of 2020 subsided quickly, we have experienced intermittent bouts of volatility since and those are expected to continue. Overall, however, the market has rebounded quickly and reached new highs. As that extreme volatility fades in the rearview mirror though, the lesson of how violently the markets can fall and how alternatives were able to cushion the blow remain.
Against the backdrop of volatility, we urge caution. Alternatives continue to play a strategic role within portfolios as a diversifier and tool for generating a differentiated source of returns and minimizing drawdowns. But the gravitational pull towards equities against alternatives remains strong.
The current market backdrop feeds into some of the most common behavioral biases that befell investors, inviting them to shed alternative investments from their portfolio. Advisors can help their clients stay the course if they make them aware of those biases and put them in context with the current climate. Consider some of the biases at work:
Anchoring: When investors anchor, they tether their decisions to a single reference point, losing context of the bigger picture. For investors in today’s market, what would that reference point be? Likely one of continuous record-breaking highs in equity markets. Even since the beginning of 2021, the market has hit record highs.
In such buoyant markets, it’s easy to lose sight of the bigger picture: Prolonged bear markets can and do happen. While the bear market experienced early last year was the shortest in history, U.S. equities have experienced three other bear markets since 1990 that have coincided with recessions. Alternatives have the potential to cushion those falls, helping portfolios recover faster so they can get back to compounding. Case in point, long/short equity strategies lost about 20 percent, on average, during the Great Financial Crisis, but nowhere near the losses of 50 percent or more experienced by many equity indices.
Recency Bias: When investors exhibit recency bias, they let current market performance warp their assumptions about how markets will behave in the future. The oft-used compliance statement that “past performance is no guarantee of future results” goes right out the window.
Recency bias today doesn’t just give investors a false sense of security about the trajectory of equities. It gives them a false sense of overall market tranquility. For perspective: The longest running equity bull market in history ended early last year and despite some intermittent volatility since, the market has continued to move upward.
In a market with such short periods of volatility, it’s easy to believe one doesn’t need alternatives to protect against volatile events.
Fear of Missing Out: As stocks heat up, it’s tempting to get greedy. When investors see heady S&P 500 gains with average annual returns of 13.5% over the last decade and their own returns held back by a drag from their alternatives allocation, behavioral instincts may urge them to ditch the allocation in favor of owning more stocks.1
Investors should resist such temptations. While behavioral impulses are hard to ignore, clients are better served when they put emotions aside and invest rationally. Long-term asset allocations are guardrails for a portfolio. They keep our behavioral instincts in check and prevent us from acting to our detriment when the ride is too smooth … or too harrowing. Hold on to the alternatives allocation. The ride will get bumpy again.
For more information visit our Alternatives Resource Center >