SAN FRANCISCO ( TheStreet) -- Erik Davidson, director of investments at Wells Fargo's ( WFC) private bank, knows a thing or two about risk.
Erik Davidson
Erik Davidson

Davidson spent time on Wall Street during the 1980s, in Tokyo during the 1990s and has been advising wealthy clients through an unprecedented market crash and economic downturn in one of the hardest-hit areas of the country: California.

Still, he remains bullish.

At Wells Fargo, Davidson oversees investments for wealthy West Coast clients, who tend to have about $10 million in assets. Davidson sees this as a time of opportunity for investors, not a time to hide under the mattress with a horde of cash. He spoke with TheStreet about how investors should react to market volatility, what should be in their portfolios, the biggest mistakes he sees them making today and how an investor could have earned a 45% return during the "lost decade" of the 2000s, when stocks plunged 25%.

The following interview was edited and condensed for clarity:

TheStreet: What can investors learn from the crisis in terms of risk management?

Davidson: In a military sense, you've always got to be careful about trying to fight the last war. And in an investor sense, you've always got to be careful about trying to fight -- or trying to protect yourself against -- the last risk.

People are so fearful of another market crash, and we just don't think that that's likely. It doesn't mean that investors should not be fearful, but we think there are other things they should be fearful of.

Those would include higher taxes -- because that is a certainty, taxes are going higher; higher interest rates -- it's fairly certain that that's going to happen eventually; and then higher inflation. Within the context of most investors' time frames -- five, 10, 15, 20 years -- we think we will definitely be seeing higher inflation than we're seeing today.

TheStreet: Some people have the idea that risk-management is just irrelevant because of black swans, fat tails, whatever cliché you want to use. How do you respond to that?

Davidson: Here's an example that I would use.

So, a plane crashes, right? And that's a tragedy and many times people will die. But does that mean that the next day that we don't get on airplanes? Well no, by no means. Does that mean the next day, because a plane crashes, that we throw out everything we've learned in aeronautical science since the Wright Brothers? Well no, we'll try to make improvements and tweaks. Or if somebody dies in a hospital, does that mean that we throw out everything we've learned about medical science since Hippocrates? No, that's ridiculous.

And so likewise, I think it's fallacious, this idea that we would throw out everything we have learned in the financial sciences simply because markets crash. They have crashed, they are crashing and they will crash in the future. We just need to ... minimize the impact of it. The fundamentals of modern portfolio theory -- of asset allocation, diversification -- not only should they not be dismissed but they should be more embraced.

TheStreet: I wrote one story recently about "the guy who got flash crashed" , perhaps by high-frequency trading, on his Procter & Gamble (PG) stock sale on May 6, and another story about "the death of buy and hold." The markets have changed dramatically, with new technologies affecting prices like they never have before. How has that affected the way people manage risk -- or the way people should manage risk?

Davidson: "Buy and hold" gets used derisively quite often and, I think, rightfully so. Frankly, I wish we had stopped using the term because, unfortunately, the challenge is that when you say "buy and hold," it doesn't mean "buy and let it mold."

People think you just buy it and you forget it. But the message of buy and hold is that you have a strategy that you deploy over the long term. Sticking to a strategy does not mean just putting your car in cruise-control and letting it go off a cliff. So a term I'm trying to use much more is this whole idea of "buy and manage."

For example, if you bought stocks and bonds in a ratio of 60% to 40% at the top of the market in October 2007, at the bottom of the market -- because stocks had crashed and bonds had rallied -- the percentage weighting had actually inverted. So it went from being 60-40 to 40-60.

A buy-and-hold strategy would say, "Okay, well, just ride it out," right? But a "buy and manage" strategy says, "Now that stocks have fallen and bonds have rallied, I'm going to rebalance. I'm going to sell high -- I'm going to sell these bonds that have rallied -- and buy low -- I'm going to buy these stocks that have crashed. I'm going to reset my asset allocation back to its original 60-40.

Obviously doing that, in March of 2009, paid a huge benefit because stocks rallied.

But, phew, those are tough decisions, right? In March of 2009, when we were meeting with clients and looking them in the eye -- frankly, just getting them to keep their current equity holdings is a challenge enough. Yet, really, academically, what you need to be doing is not only keeping your current exposure to stocks, but you actually need to be increasing it to keep your original 60-40 weighting.

TheStreet: What is the most sensible mix of assets for the average investor?

Davidson: The first and most important thing is to have some sum of money -- we call it the "sleep-well number." Whatever amount of money -- that six months of living expenses; is it a year? -- that will help investors sleep well at night.

The second thing is, you want to know what your goals are. A lot of times people will just say, "Ah, I want to make money; I don't want to lose money." Well, those aren't really goals. What is the money for? What are you going to do with it? Is it for retirement? Is it for a kid's college education? Is it for purchasing a second home? Is it for legacy and philanthropy goals?

When you have the timeframe for that, then you can create a portfolio that calibrates with those goals.

Our belief is that every portfolio has to have four major components: It's going to have to have stocks; it's going to have to have bonds; it's going to have to have what we call real assets, which are things you can touch and feel, which includes real estate, includes commodities; and then it's also going to have to have what we call complementary strategies: hedge funds and those sort of things.

No matter how aggressive nor how conservative you are, you want to have some of each of those four components.

TheStreet: What's wrong with the average investor's portfolio?

The big mistake that investors are making today, because of what we've been through, is they've become extremely fearful. Even though they have goals that are 10, 20, 30 years out, they're taking strategies that are extremely short-term in orientation because they're so concerned about losing money.

Witness today, just the trillions of dollars that investors have in money-market funds. Much more money in money-market funds than is normal. A money-market fund, if you're lucky, is going to earn you one-eighth of 1% -- if you're lucky. You're going to double your money in 553 years.

How can that get you to your goals? It can't.

TheStreet: What were your own personal emotions, whether in March of 2009 or more recently, with all the volatility?

Davidson: My first reaction is always one of being a contrarian.

So, when I see, for example, everybody getting excited about gold these days, I get very, very skeptical about gold. When I see everybody getting excited about Treasury bonds, and today we have yields going below 3% again, I get very skeptical about that.

When we were going through what we were going through in March of 2009, there was just so much going on. Even I was getting down to the brass tacks with my emotions of fear and greed.

But as I sorted through it in my mind, it really was never, "Should we just bail out?" It was like, "At what point is the right point to get in? Because it's definitely on sale here, but can it go from cheap to cheaper?"

TheStreet: What do your own personal investments look like?

Davidson: Just talking about retirement, which is kind of a 20-to-30 year goal, it's definitely on more on the aggressive side than probably is typical.

In rough numbers, it's 75% stocks, 10% in real assets - commodities and real-estate sort of stuff -- another 10% in complementary sort of hedge funds, something that zigs when everything else is zagging. The bond allocation is extremely low, but even then, I still have some bonds. I still have about 5%.

The interesting thing, and probably the atypical that we here in the United States have become very provincial in terms of our investment thinking. And the world has changed: 97% of the world's population is outside of the United States; three-quarters of the world's economic production is outside of the United States; and even two-thirds of the world's market capitalization is outside of the United States.

At Wells Fargo, we believe that, you know, basically, at the very least, you should have a two-to-one ratio. So, for every two dollars that you have invested in the United States, probably one dollar should be overseas. So no matter where you are, or in terms of your asset allocation, if you have x invested in stocks, you should have one-third of that, at the very least, invested overseas. Likewise with bonds and likewise with everything else.

For myself ... it's actually more of a one-to-one ratio. So for every dollar I have invested in the U.S. - so that 75% in stocks I have, it's about half and half.

TheStreet: But you're saying that it should be two-for-one at the bare minimum?

Davidson: Yea, so, no matter where you are - even if you're very conservative, and let's say you only have 30% invested in stocks, right? Of that, probably10% of that should be overseas and 20% in the U.S.

Too many U.S. investors are just so scared of being invested overseas -- and you know, understandably so. Particularly as we see stuff going on in Europe, and now China and all that. But the opportunities are there.

As Americans we kind of lament at times the un-level playing field of foreign trade that we play on, and foreign competition and what not. And those are all valid issues and concerns. But from an investment sense, if you can't beat 'em, buy 'em, right? If I'm worried about competition from China or India -- again, those are very real issues that we need to grapple with as a country but as an investor, why don't I take advantage and go buy companies in China; go buy companies in India, right?

TheStreet: What's the key takeaway for investors for what we've been through over the past few years?

People look at this past decade and say stocks lost 25%. Yeah, but a diversified investor who had stocks, yes, but also had international stocks, also had bonds, also had real estate, also had commodities, also had hedge funds and such - that diversified investor was up 45% for the decade.

This past decade was actually worse than the '30s for the stock market. You take the worst decade in modern history, and you have a 45% return for diversified investments - that's not bad, right? It wasn't a lost decade by any means.

-- The interview was conducted and condensed by Lauren Tara LaCapra in New York.

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