Even though the long-term goal of investors is often capital preservation, fear of missing out — or FOMO — leads many to ask why alternatives need to be part of a portfolio when stocks and bonds are marching ever higher.
While many market observers would say unease has increased this year amid headlines about yield curve inversion, trade wars and a deteriorating outlook for global growth, the VIX index of implied future volatility has declined 54% since December 2018 to near its historical median.
The periods of volatility that have appeared this year have often been short-lived with markets quickly mean-reverting and resuming an upward trajectory after initial fears of contagion dissipated. One example would be on Wednesday, August 14 when the S&P 500 fell 2.93% only to rebound by the following Monday.
The smooth upward ride of the market, coupled with these fleeting bouts of volatility, is understandably causing advisors to have to justify to clients the inclusion of alternatives in their portfolio. Clearly the problem with this dichotomy is that it is putting pressure on advisors to make long-term portfolio decisions based on ultra-short-term performance periods.
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From a behavioral aspect, as data sets and problems become more complicated, humans tend to rely on biases to heavily influence their decision heuristic. One would never take their retirement savings the day they retire and put it on red in Vegas with the hopes of multiplying their money simply because red just won — that’s irrational. So why would one evaluate the performance of any position, including alternatives, over what are short timeframes by investing standards?
During conversations with clients, advisors should urge them to resist FOMO and recency bias and to remember why a meaningful long-term allocation to alternatives can provide much-needed diversification and downside protection in a carefully constructed portfolio designed to perform over a whole cycle.
Two examples include the DotCom bust in which over an eighteen-month period, from April 2000 through September 2002, the S&P 500 and MSCI World Index shed more than 40% each and slumped by about 50% during the Great Financial Crisis from June 2007 through February 2009. For investors, the impact of these time periods on the realized long-term portfolio returns far exceeded the period specific negative returns as investors fled their investment strategies for cash positions because the fear of loss was too great, which, of course in turn, caused many to miss out on the market rebounds that followed. In those same turbulent periods, the Credit Suisse Managed Futures Index surged 32.6% and 19.5%, respectively. A well-diversified portfolio would have likely kept investors invested during these periods of uncertainty.