If you think destroying 60% or 80% of an investment’s performance is bad, imagine destroying more than 100% of it.
This is what investors do to their alternatives allocations each and every year.
Research from Dalbar tells us every year that investors are destroying roughly 60% of their stock performance and close to 80% of their bond performance. This is consistent and directly related to greed and fear.
But greed and fear are not sufficient to explain why investors destroy more of their bond returns than their stock returns.
In fact, because stocks tend to be more volatile (more fear) and offer higher return potential (more greed) you would expect that investors would destroy more of their stock return than their bond return.
There must be another factor consistently in play: fear of the unknown. In this case, the fear of the unknown risks.
Misunderstanding risk has real consequences
Stocks have one core risk: the risk of ownership. In its basic form, equities investing tracks whether the price of a stock goes up or down and whether the value of the stock tracks that movement.
Bonds, however, have two main risks:
- Credit risk, or the risk that the governmental body or corporate entity you lent to won’t pay you back.
- Interest rate risk, or the risk that interest rates will move and affect the value of your loan.
This second risk, also known as duration risk, creates a lot of unknown for investors.
Because bond risk is harder to understand for the average investor than stock risk, they’re more fearful of their performance. That’s why investors consistently destroy more returns from bonds.
If this logic holds, then no wonder investors are unlikely to have a positive experience with alternatives.
The types of risk that alternatives take are more numerous, more complex and certainly less understood than the risks of either stocks or bonds. What’s more, Wall Street has failed to provide a consistent definition of what they should do for your portfolio and what quality looks like. Because of this, investors are highly likely to destroy 100% (if not more than 100%) of the performance from their alternative investments.
This blend of greed, fear and misunderstanding is hugely impacting investors at a time when they need to diversify risk most. Investors who truly diversify their assets now may help thwart the impending reversal of the 35-year bull market in bonds that lost trillions in November 2016 alone. Proper allocation to alternatives may also reduce the risk that crowding into passively managed equities creates in case of market reversal.
What can investors do to shake off these pervasive market forces?
- Clearly define goals around what you want your portfolio to do over the long-term
- Allocate to a basket of investments that take a variety of risks rather than chasing diversified performance
- Rebalance at least once a year as not to fall prey to emotional decisions
To help ensure that investors follow through after their investment intervention, advisors can encourage these behaviors with their clients.
Article by Longboard