Investors did a strange thing in 2012, according to a survey sponsored last year by Natixis Global Asset Management: 57% said they wouldn’t cut their cash holdings—and this was during a period when interest rates were reaching historic lows and the stock market was zooming upward.

Robert Hussey, NatixisFor advisors in 2013, the challenge will be guiding investors to use strategies that go beyond cash to benefit them in the long term, says Robert Hussey (left), an executive vice president for NGAM, which oversees $700 billion in assets. Hussey leads NGAM’s relationships with investment consultants, independent financial advisors and wealth management firms.

“Investors are a bit scared. I don’t know that they’ve recovered fully from the experience of 2008,” Hussey said in a recent interview with AdvisorOne. “Market volatility over the last three to four years has increased, and for high-net-worth individuals, not losing what they’ve built up over the last few years is important. Capital preservation and not chasing returns is a much more prevalent notion in the investor mind than it was five years ago, but folks still have an investment goal to achieve and they need a strategy that delivers a return.”

Wilmington Trust, on the other hand, reminds advisors that studying irrational investor preferences can actually help them with client portfolio construction.

“While valuations matter, they are not the only important variable in investing. Trends in investor preferences matter, too,” wrote Wilmington Trust Investment Advisors in its December Capital Markets Forecast. “Consider the December 1996 warning from then-Fed Chairman Alan Greenspan of ‘irrational exuberance’ in the markets. The shakeout in share prices did not commence until March 2000. In the intervening years, many observed that technology, media, and telecommunications stocks appeared to be in a bubble, but their prices, and those of most stocks, continued to climb. For years investors’ preferences mattered more than valuations.”

In short, advisors who keep an eye on the curious and sometimes counterproductive behavior of investors can discover strategies for combating lackluster returns in their own clients’ portfolios.

Despite retail investors’ current preference for cash and low-yielding bonds, Wilmington Trust urges advisors to stay away from core bonds, including U.S. Treasuries as well as investment-grade corporate and municipal bonds and mortgage-backed securities. The firm is neutral on cash equivalents, but it also discourages investment in inflation hedges such as inflation-linked bonds and commodity and real estate securities along with growth stocks and mid- and small-cap U.S. stocks.

So what does Wilmington Trust see as a good value? Noncore fixed income, such as emerging-market debt and speculative-grade municipal bonds; value stocks and large-cap U.S. stocks; developed international equity markets, particularly large-cap value stocks; and emerging equity markets.

When clients pressure advisors to make preference-driven investments, Hussey offers these three tips to help manage those fears of risk and volatility:

  1. Reduce emotions in investment decisions: Advisors can start by helping investors understand risk and prompt investors to think about how much downside risk they’re willing to take before setting return objectives. When clients discover their risk tolerance, they’re less likely to make impulsive decisions. (The good news for advisors is that clients want to talk about risk, Hussey says. A recent Natixis survey shows that 62% of investors said they’re interested in discussing the topic with their advisors.)
  2. Stop thinking of asset classes as “good” or “bad”: Investors need reminding that markets are dynamic, and while some asset categories are cheap and others are expensive, conditions are never permanent, Hussey said.
  3. Avoid analyzing investments in a vacuum: Every investment carries some risk. That risk should be measured by how it affects the entire portfolio. Advisors can educate clients that the right risky assets can actually bring down overall portfolio risk if their correlations are low enough.

“The durable portfolio construction message that we deliver to clients is to view an investment product as either a risk reducer to the portfolio or a return enhancer,” Hussey said. “By identifying the sources of risk, that’s the first step for the advisor toward building a portfolio that offers a smooth ride in this environment of higher volatility.”