Washington Trust Bank Blog | Returns Suffer When Emotions Rule

Returns Suffer When Emotions Rule

I have been inundated lately with questions regarding articles dealing with the withdrawal of assets from liquid alternative funds. Liquid alternatives, as the name implies, are alternative assets like hedge funds that are now available through mutual funds. Unlike private placements—the traditional way to invest in alternatives—mutual funds are readily tradable, hence the term liquid. People are worried that these strategies are just a passing fad and do not have any investment merit.

To me, this reaction is to be expected. After three years of double digit growth in the S&P 500, risk is no longer a concern and everyone wants to jump on the stock bandwagon. We have seen this type of herd mentality before—the tech bubble in the late 1990s, and the real estate bubble in the early 2000s, are just a couple of the most recent examples. Unfortunately this is why many investors fall short of their long-term goals. It belongs to a discipline called behavioral finance—the study of how emotions and mental mistakes influence investors’ decisions. We recently had an internal seminar dealing with this subject, led by my colleague Derrick Wilson. Basically, investors are not always rational. Their decisions can be biased by recent history, overconfidence, and denial of risk.

This irrationality leads investors to move in and out of asset classes based on recent performance, and as we all know, past performance is no indication of future results. However, as humans, it is hard to overcome the urge to move out of bad performers and move into recent winners. Regrettably, asset class performance varies significantly from year to year, and last year’s winners are rarely next year’s winners. As a result, the average fund investor’s returns fall far behind the average return for most asset classes, year after year. See below:

And this brings me back to my original point. Investors are moving out of liquid alternatives, not because they lack value, but because of hind-sight bias and herd mentality. Everyone wants those double digit gains the S&P gave us during the past three years. Unfortunately, you can’t buy those returns and tomorrow’s may be completely different. Ironically, most investors’ returns were enhanced by their alternative holdings last year. While the S&P 500 was up over 13%, most international stock indices were down and small cap stocks registered only single digit returns. The out-sized return from stocks was very narrow.

Sadly, in all of this, risk management is not even part of the discussion. Alternative assets are not added to simply provide better returns. Like every other asset, sometimes they will improve returns and sometimes they will not, but they always offer a different source of returns. Therefore, they improve diversification which in turn improves returns for the level of risk. The idea is no different than holding twenty stocks instead of just one.

The moral here is to remain diversified and fight the urge to buy yesterday’s returns. Just as we are now seeing a dash into stocks, we of course will see the opposite behavior after stocks have a down year. By maintaining diversity, long-term returns will be improved and volatility will be lowered, which should make it easier to stay disciplined. As a result, the chance of meeting your goals increases.

 

Washington Trust Bank believes that the information provided was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.

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