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Shaking Off the Market Shocks

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. Now that we've had a chance to sleep on quite a wild ride in the market on Thursday, what do investors do today? How should they think about their portfolios? How should they think about the risks and the opportunities that may be out there, given all the market activity that we've seen?

I'm here with Morningstar markets editor, Jeremy Glaser and Christine Benz. She's Morningstar's Director of Personal Finance. Thanks for joining me, guys.

Christine Benz: Nice to be here.

Jeremy Glaser: You're welcome, Jason.

Stipp: Yesterday, I think, looking back on it, it potentially could be a learning experience for investors and what their risk tolerance is. We saw quite a spike of downward volatility yesterday. How should investors think about this, as far as how much risk they can tolerate, and does this day change things for people?

Benz: Well, I think it's a mistake to let risk tolerance drive what you do because, in my experience, investors are a terrible judge of what their risk tolerance is. So I come back to having a plan, the importance of having a plan. The people who seem to have the worst experience at times like these, are those who don't have a plan.

So if you don't have one, get one. If you have one, check to see how you're doing versus that plan. Maybe you're allocations are up or down versus what your targets are. And that would be a starting point.

Stipp: Jeremy, do you think anything that happened in the market yesterday changed the risk situation? I mean, is the market dramatically different Thursday than it was on Wednesday? Or what exactly do you think happened with risk yesterday?

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Glaser: I think the first thing people need to see is that that thousand point drop was somewhat of an illusion. That, yes, it actually happened, but a lot of it was driven by probably some glitches, or some trades that were not placed in exactly the right way. So it doesn't mean that people shouldn't be worried about volatility, but I think investors should focus more on the fact that we're down three-and-a-half percent, and not down 10 percent on the market. Which would I think present a completely different story than what we'd be talking about right now.

I think it's a continuation of the risk that we've seen before. That we've moved from a credit risk, where people are worried about bank credit, into a sovereign debt risk, where people are worried about how governments, who had to spend a lot of money to bail out the banking sector, how are they going to be able to pay that back over time? That's what people are concerned about right now.

And the way that governments act, and the way that deficit spending works, it's going to have impacts on end demand for people in Europe. It's going to have impacts on end demand for people in the United States. And I think those are the concerns that have investors worried right now. And the ones that are driving what stocks are really seeing the biggest hit and which ones are holding up a little bit better.

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Stipp: Sure. Now, Christine, as you look at your risk, if you feel like you are taking on more risk than you thought, or more risk than you can handle, what steps should you take? Does it seem like a good idea to sell now, given that we did see so many people selling? Or how should you ratchet back your risk, if you think you need to?

Benz: Well, each individual's situation is different, of course, but one good starting point is to see what your cash allocation is. So, to see that you have enough reserves to get you through whatever might come. So if you're a working person, you'd want three to six months worth of living expenses in cash. And if you are retired, two to five years I think is a good rule of thumb. So make sure you have that bucket of money that is locked away. And you can't afford to lose it, so keep it safe.

Stipp: Sure, and so that way, if you do need to have some things in riskier investments, you know that they're farther out in the future, you're not going to have to touch them for a while, you can potentially ride out a time like we had yesterday.

Benz: Exactly. Exactly.

Glaser: And I would say, as we've said before, this is why thinking of dividend-paying stocks as a substitute for something like Treasuries, or a substitute for fixed income, doesn't really work in an asset allocation, because you can have days where you have this much volatility. And if you need that money to be there, you're going to be glad you had it in a safer investment, even if you are getting zero percent.

Benz: That's a great point, Jeremy. Because I think, ultimately, this all-or-nothing mentality is not helpful. So, there's been a lot of buzz over the past year about Treasuries being a terrible place to be. Well, Treasuries are a real anchor on a day like yesterday, so you don't want to eliminate them entirely from your portfolio; they're an important part of the bond market.

Stipp: Now, flipping the conversation a little bit, going from risk to potential opportunity. I think a lot of people have been waiting for a pullback to maybe put more money back to work. So as you're thinking where the opportunities may be, also keeping in mind that there are some real risks out there, is it reasonable to think that no valuations have changed from yesterday? How should you think about what could be a value today and what actually fell for a good reason?

Glaser: Valuations absolutely changed. I think, as we said before, there are actual fundamental risk factors that are driving a lot of the market volatility that we're seeing right now. But there's lots of high-quality companies that have great competitive advantages that are starting to get cheap again. We saw them being incredibly cheap in March of last year, and we're not anywhere near those levels again, but they're pulling back a little bit from their highs. And it could present an opportunity.

I think investors need to think about why they would own a different stock. What's the investment story that they're buying into? Is it that they're going to see great growth between European consumers? Maybe that's not a great bet right now. But if it's making a bet on Asian growth, or making a bet that the United States is going to be able to pull out of the recovery ahead of the rest of the world, or on par with Asia, it might still make sense for investors to be in that stock.

So, as always, you really have to evaluate the fundamentals of an individual company. Think about if they have the liquidity, and they have the balance sheet strength, to make it through another potential downturn, make it through another potential issue with credit. And if you can find those companies, and they're trading for a discount to their intrinsic value, maybe they have a good dividend yield on them, maybe they don't, but it could be an interesting place for investors. And there looks like there will be some opportunities to put money to work, where in the last couple of months, there really haven't been as many.

Stipp: Christine, could now be a good time to maybe upgrade your portfolio a little bit?

Benz: That's what I'm thinking, Jason, because our stock analysts' valuations have certainly been telling us that quality is relatively cheap right now, on the stock side. So I think it's a good market to not be too fancy. We've see a lot of lower-quality asset classes have very strong runs, with the exception of the past month or so. So it may be a good opportunity to take some risk off the table, upgrade both the stock and bond sleeves of the portfolio.

Stipp: Last question for you guys. I think that, on the technical side, or on the investing side, Wall Street again potentially taking another hit, if a glitch here has caused all this market volatility. Real money was lost yesterday, even if it was just based on a technical glitch. What are the possible side effects of this for investors?

Glaser: I would say certainly it kind of adds this perception that Wall Street is out to trade for themselves, and make money for themselves. And that individuals kind of get left out of the party, or don't have access to the same kind of opportunities that the big banks and Wall Street does. We can argue whether that's actually true or not.

But I think certainly as the Senate is continuing to make the financial reform bill, and people are still having a simmering anger about bank bailouts, and TARP, and programs like that, I think you could see a continuing move of people potentially dropping out of the market. Or at least the sentiment I think could be very negative for a while, probably much more so than some of the fundamentals might necessarily dictate.

Stipp: Sure. Christine, for long-term investors, are some of these issues really issues? Maybe you feel like you can't get that great price that was available on Procter & Gamble yesterday. But if you're a long-term investor, and you're in the market, should you worry too much about some of that little bit of a drag that maybe some of this institutional trading might cause for an individual investor to not be able to trade on the same level?

Benz: Probably not. And, as you know, I'm a very long-term oriented investor, and would urge most individual investors to do the same. And another thing to keep in mind, I guess, for people who are feeling like the deck is stacked against them, in Wall Street's terms, to think about maybe having a mutual fund, where at least you do have that institutional money manager working on your behalf.

Stipp: Sure. Christine and Jeremy, thanks so much for joining me today, and for your insights and the reflection on this very much a roller coaster day in the market this week.

Benz: Thanks, Jason.

Glaser: You're welcome.

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