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Muldowney: Gauging Risk After Lehman

Jason Stipp

Stipp: What is your take and perspective on risk going forward? Given the last year that we've had in the markets, has that changed at all?

Muldowney: Well, our outlook has changed. But I think it's important, before we get to the change in risk, to identify how that extra risk got built into the marketplace.

I would first suggest that if we were to look back three years ago, pretty much everybody in the marketplace felt pretty comfortable. We had taken an awful lot for granted.

Markets were good. Money was cheap. Markets were expanding. More people were enjoying homeownership with low-cost money and interest rates certainly that were as low as they were.

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Because there was more money chasing after a fixed number of products, whether it be houses or stocks, it artificially inflated the price of those stocks. The artificial inflation causes people to say to themselves "I want some of that." Consequently, they will chase after the purchase of either those stocks or those homes.

When the subprime crisis made it very clear that there is no such thing as cheap money - we do end up paying for it - folks who borrowed money... and I'll give an example. Let's suppose they borrowed a half a million dollars to get into a half a million dollar house with no down payment. They had the reasonable expectation, certainly at the time, that they'd be able to sell that house five years later for $600,000.

When it came to the fact that the house was only worth $400,000, and they couldn't sell it but they had a half a million dollar mortgage, they simply walked away.

So, many of the foreclosures that you're hearing about, those are foreclosures on houses that have been vacant for a very long time. Foreclosures are very clearly not good for the consumer, but it's even tougher on the banks. What it does is it impairs their ability to make other banking decisions.

Well, with the prices inflated artificially and then the banks running out of money, part of the collapse was necessary and appropriate because we paid too much for stocks. We paid too much for our houses.

The next layer gets to the point where we see a massive deleveraging. The hedge funds and private equity firms, perhaps as well as many individual borrowers, had to redeem assets that they owned in one form to pay back loans. That caused a further reduction in the market value of the companies or the stocks that we would have owned.

I would look at it from the standpoint of saying since we have had the opportunity to take that excess risk out of the market, clearly against our will, clearly unanticipated, but it's gone, I think it's safe to come back and say that the companies that are in this country and companies all across the world are back in the business of manufacturing their good, healthy, wholesome products that people want to buy.

Now, as far as the risk is concerned, yes, three years ago we took an awful lot for granted as an entire marketplace. We felt we had control when it was nothing more than the illusion of control.

Now that we've seen our retirement nest eggs kicked in the teeth, and many of us are looking at working a few extra years in order to make up what seemed to have disappeared from our portfolios, we are encouraging clients to take a little bit more of a less-risky position in their investment portfolios.

Stipp: OK. One of the other things that we hear from investors a lot after the crisis, they're looking at risk, but they're also wondering if I was a buy-and-hold investor, that doesn't seem to have worked out too well for me over the last few years.

Is that philosophy gone? Should I be thinking about investing differently and moving money around more strategically? What sort of plan is going to help me ride out some of these things without the kind of losses that I had to endure?

Muldowney: Well, buy and hold can be looked at in a variety of different ways. One of the ways to look at buy and hold is to simply buy good companies, own them for the cash flows that those companies will generate, and more or less own those companies in perpetuity.

The press has done a pretty fine job when they come back and take a look at something like the S&P 500. Our company has had a great fondness for Vanguard's S&P 500 Index Fund since 1989.

Ultimately, what it amounts to is if someone had bought an S&P 500 index fund, and reinvested all the dividends, and held it from about 1997 to 2009, they would find that there's a big M-shape in the value of their holdings.

It increased from about 1995 to 2000. From 2000 to 2003 it dropped. From 2003 to 2007, it went up, and from 2007 to 2009, it went down precipitously.

So, the press would be fair in coming back and saying, well, a buyer of the S&P or a holder of a market basket of securities that never did anything hasn't made any money. I think that's a fair representation.

Instead, we would come back and say the investor would be better served to have a buy-and-hold strategy coupled with an allocation strategy.

By establishing an allocation, you have a target, and it automatically forces you to sell an asset when it's overpriced and to buy assets when they represent an unusual opportunity.

It's not so much that buy and sell is a clumsy strategy. It's more a matter of can I couple buy and hold with an allocation strategy to assure that I can make money.

We had the opportunity to talk about taking an artificial basket of eight different asset classes and simply dividing them into 12.5 percentage slices apiece, and then every year for 20 years rebalancing to our 12.5 percent target allocation.

By doing that, going back to 1989, the investor would have earned about an average rate of return of 8.9 percent average annual compounded through this entire rise in the market, and multiple crashes, and multiple rises.

So, buy and hold coupled with an allocation strategy makes great sense.

Stipp: So that discipline that's imposed by the rebalancing means that you'll be selling things that may be a little bit overpriced, and perhaps buying some things that may be a little bit underpriced in relative terms.

Muldowney: Yes.

Stipp: In your target allocations, has anything about those changed when you're looking at some of your clients' portfolios, given the events of the last year?

Have you tweaked what some of those targets might be going forward, given that some things may have been riskier than we thought and maybe some things had perhaps more relative safety than we anticipated?

Muldowney: Well, as a matter of fact, the answer to that is yes, but we'll probably surprise you as to how we did that.

First of all, we take a look at our investors and encourage them when they're making any investment at any time, the ultimate purpose of that investment should be to produce a cash flow.

Under good circumstances or ideal circumstances, the investor would want to have that cash flow grow. About the only place that you can do that is by having ownership of a very, very broad base of stocks.

The changes that we did make in our portfolios over the course of the past year would have been relegated specifically to the bond portion. We've been great proponents of short and intermediate-term bonds, but we've also got a healthy allocation of our portfolio to inflation-protected bonds.

For our short and intermediate-term bonds, during the throes of the credit crisis we changed the funds out and moved to more government or agency bonds because they offered a greater stability than we thought was available in the traditional corporate marketplace.

Stipp: OK. Final question for you: We're hearing from a lot of our readers. They're saying that they're out of the market entirely.

When things got really, really bad last fall and continued into the first part of this year, they just couldn't handle it anymore, and they sold everything. They're sitting on a lot of cash.

What would be your advice to someone that's got a big cash stake, and now has seen quite a run-up in the market, and is wondering, "What should I do now? How should I redeploy that money?"

Muldowney: Well, there's certainly a clumsiness for staying in cash. The first reason is that any interest that you earn is going to be taxed as ordinary income. The second reason is inflation is probably in the range of three percent on average over the long run.

Consequently, if you're losing a portion of your money to tax and you're losing another portion of it to inflation, sitting in the money market, once again, is the illusion of control. You're actually losing money.

We encourage clients to have investments that generate cash flow, so they have one of two options. One of them is to take that investment money that is sitting on the sidelines and redeploy it into their original target allocation.

Their choices are to do it one of two ways. They can do it all at once, or they can redeploy it over a period of time using a technique, dollar-cost averaging.

We are not as concerned what technique they use, although in general we would tell our clients we think it is reasonable and appropriate for you to redeploy according to your original strategy all at once.

But, the important part is that they get back into the market, so if those that are still a little bit more anxious about what they see in the financial environment and what they see for those companies, dollar-cost averaging is not a bad or inappropriate way to get back in.

One of the challenges that I see with dollar-cost averaging is that you are often dollar-cost averaging back into the same market. Therefore, if we're seeing a generally uphill-moving market today, if they're dollar-cost averaging it, they're leaving a little bit of money on the table.

Stipp: Great. Well, thanks so much for your insights today, Tom. I really appreciate it.

Muldowney: Jason, I hope it's good for you and your viewers.

Stipp: For Morningstar.com, I'm Jason Stipp. Thanks for watching.