Hedge funds made money while equities lost value.

Investors took different lessons from the situation. Some thought they had achieved optimal risk-reduction through diversification in spite of owning no alternative investments, but they suffered real losses. The wiser few saw the opportunity for profit and risk-reduction through the addition of hedge funds and private equity to their portfolios. A little-known fact is that through November, those with robust alternative investment portfolios experienced less volatility and continued gains, on average.

Contrary to popular wisdom, now may be a good time to embrace hedge funds and other alternative investments. History has shown that inflection points in the markets, when securities valuations here and abroad are severely imbalanced, have tended to be times of opportunity. When markets are volatile, hedge funds buy mis-priced debt and equity securities and hedge them by selling short indexes or other overvalued instruments. Because they focus on absolute returns—how much they can make relative to zero—they are often profitable and less volatile. For example, at similar times from 2000 to 2002, hedge funds made money while equities lost value.

In times of fear, historically there have been wider spreads on debt, lower earnings multiples on equity, bigger premiums for merger transactions, and greater disparities in performance among markets in the U.S., Europe, Asia and the emerging markets—which have all presented opportunities to talented alternative managers. During the dot-com bust, from 2000 to 2002, the S&P fell by 37.6 percent and the Nasdaq dropped by 67.2 percent, while the average U.S. equity hedge fund earned 4.4 percent. Alternatives zigged while equities zagged.

Determining the right time to enter into an investment is difficult, because inflection points are only obvious in hindsight. Yet there are indicators that this may be such a time. Rising market volatility, a debate about the probability of recession, unusual market conditions like those in fixed-income securities, and the disparate views of central banks in Asia, Europe and the U.S. indicate a financial-market tug-of-war. Opportunities for long-term investors abound when market conditions are in doubt. Bad news in U.S. residential real estate may have no major impact on commercial real estate here and abroad. Private equity deals may be tough to accomplish today, but those that are completed are likely to be of higher quality. In short, discerning investors can change their risk-and-return profiles by reallocating their portfolios.

Given almost universal anxiety among investors about the markets, many advisors suggest alternative investments to deliver equity returns without equity volatility and downside. Real estate, private equity, hedge funds and venture capital have long track records of profitability through a wide variety of equity and fixed-income market cycles. Sophisticated investors, such as foundations, endowments and pension funds, have been using alternative investments successfully for decades. A 2006 report by the National Association of College and University Business Officers suggests that the most successful foundations have the highest allocation to alternatives and achieve the best investment results, marrying quantity and quality of alternative investments.

We will look back at this time in the financial markets with wonder. An unprecedented residential real estate devaluation was underway even as the economy grew, and highly rated bonds became junk in less than a year. Is this an inflection point? It sure feels like one. But regardless of what history will show, it is likely that those who have truly diversified portfolios, including a meaningful allocation to alternatives, will have a smoother ride.

David Bailin is the head of the Alternative Investment Group, part of the Global Wealth and Investment Management division of Bank of America.