The Obvious Follow-Up Question

In the wake of the 2008-2009 mega-crisis, one of the most common responses on the part of all financial advisors and investors – myself included – was to take a great interest in strategies, products and managers that managed to avoid the drawdown. This is rational behavior. Something terrible happened, surely there must have been a solution that would have helped you avoid it – or could help you avoid it down the road.

All manner of money then poured into hedge funds, “black swan” funds, managed futures funds and all other manner of alternatives. Massive fees and relatively short track records were overlooked in the pursuit of perceived “safety” – again, this is also natural, normal behavior. After something traumatic takes place, you’ll pay almost any price to be protected from it again and you’ll ignore a lot of flaws when your savior arrives.

And now, I’ll share with you a ridiculous quote from a new Investment News feature on alternatives that illustrates one of the biggest traps that investors fall into. Here’s a financial advisor who says that his typical client portfolio includes a 30-35% allocation to alternatives:

“In 2008, when the S&P 500 lost 38%, my average portfolio went down 4% because I had alternatives in there,” he added. “It is mathematically impossible to have a properly allocated portfolio without using alternatives.”

Sounds great on the surface (regardless of the fact that it’s pretty odd to see a registered person making a performance claim like this in a public forum – hope that’s audited, pal).

But then there’s the obvious follow-up question, the question that should always be asked in the presence of a claim like this:

“Okay, minus 4% in 2008 sounds great – how did things go in the following year?” How about over the next 36 months? How much of the S&P 500’s incredible double, and subsequent triple, did you then leave on the table, as a consequence of this?”

Believe it or not, most investors aren’t equipped with the knowledge in order to come up with this follow-up question, in my experience. The realization that there is a price to pay is a painful one, and it comes on slowly as markets recover without you.

Unfortunately, many people rushed whole-hog out of the frying pan and into the fire. The solutions they ran toward carried pitfalls of their own. Insult has been added to injury – losses were compounded by lack of gains as alternatives have failed spectacularly to enable their shareholders to benefit from the market’s comeback.

The lessons:

Sometimes the cure can be just as bad as the sickness

Insurance has a cost, sometimes a higher cost than seems apparent upon purchase

Arranging an entire portfolio for once-in-a-lifetime market events, as though they are a commonplace occurrence, is severely detrimental

The continuing conflation of “risk” with “volatility” will claim new victims during every bear market

Investors without an overarching investment philosophy will be most susceptible

After the next big negative event for stocks or bonds, will you be keeping these lessons in mind?