How do you prepare for a financial cataclysm that may not happen?
That's the question facing investors as an Aug. 2 deadline approaches for Washington to raise the government's borrowing limit or risk a U.S. default on its debt.
Economists say a default could create a credit crisis similar to what happened after Lehman Brothers went bankrupt in 2008, causing interest rates to rise and harming the economy. But the reaction in the stock and bond markets has been muted.
In theory, Treasury bonds should have a higher yield when investors think there's a greater risk they won't get their money back, such as in the event of a U.S. government default.
So Wall Street appears to think a deal will be struck in time. But the alarming headlines are causing investors anxiety.
"We're seeing clients growing nervous as they keep hearing about the deadline," says Oliver Pursche, president of Gary Goldberg Financial Services in Suffern, N.Y. He says investors are asking him whether they need to change to their portfolios.
So what should you do if you're worried about a default? Here are five things to keep in mind.
1. Don't abandon your long-term plan.
Most investors who had diversified portfolios in 2008 and stuck with them have made up their losses, despite a 57 percent drop in the Standard & Poor's 500 from its peak in October 2007 to the market bottom in March 2009.
Investors who panicked and withdrew their money from the stock market have found it tougher to recover.
"Don't get waffled around emotionally by all of this short-term noise," says Michael Farr, chief investment officer of Farr, Miller & Washington, an investment firm in Washington, D.C.
2. Be wary of bonds.
Conservative investors who sought to avoid the volatility of the stock market and flocked into bonds could get burned.
A default could drive up the cost of government borrowing for years and lead to higher interest rates for everyone else. If that happens, bonds would lose value because their prices move in the opposite direction of interest rates.
Even a brief default could be enough to hurt the credit rating of U.S. debt and usher in an era of higher interest rates, cautions Greg McBride, senior financial analyst for Bankrate.com.
If you want to position yourself for an impasse on the debt ceiling, consider Treasury bills with a maturity of six months or less. Look for those maturing sometime after August. Their short-term nature means their prices are less affected by an increase in interest rates. That's because investors will receive their principal investment before there are larger changes in the economy. Investors also should steer clear of Treasury notes with a maturity of 10 years or longer because their prices may face steep price declines as interest rates climb. Bank CDs are another option, although the yields are minuscule.
3. Remember that rebalancing can be risky.
Adjusting your 401(k) retirement plan to shift money out of the stock market and into cash is always an option for nervous investors. But you should weigh the repercussions first.
If you pull money out of stocks now, you could miss a "relief rally" if the market climbs after a last-minute debt deal. Even if you're correct and move your money before a decline in the market, you'll need to get the timing right a second time when you shift back into stocks. Otherwise, there's a good chance you'll find yourself on the sidelines when market momentum shifts.
If you have only a year until retirement or you find yourself fretting over your potential losses, playing it cautious may make sense.
"Pull back a little for peace of mind if you're really worried," says Tom Root, associate professor of finance and business at Drake University. "But if you have a long-term plan, stay with it."
4. Check your emergency preparedness.
In a period of uncertainty, it's important to make sure you have access to cash in case of an emergency. Investors should set aside money for emergencies in an easily accessible account, like a money-market savings account. It's important not to have this money in an investment account because market volatility could leave you unprotected.
Ideally, a single-earner family should have enough cash set aside to cover six months or more of living expenses. A two-income family should have at least three to six months' worth, says Justin Sinnott, a financial consultant for Charles Schwab Corp. in Seattle.
5. Watch for buying and selling opportunities.
This is a good time to remember Warren Buffett's famous advice: "Be fearful when others are greedy, and be greedy when others are fearful." As more fear creeps into the market with the deadline approaching, it may be a prime time to snap up bargain stocks.
And if steep cuts to government spending are part of an agreement on the debt ceiling, keep in mind the specific industries that could be hurt the most.
Goldman Sachs issued a note to investors last week listing companies that generate at least 20 percent of their revenue from government. Many are in the health care sector, both providers and equipment suppliers, plus defense contractors.
The turbulent market in the last three years has caused many investors to be overly cautious, says Erik Davidson, deputy chief investment officer for Wells Fargo Private Bank.
During the debt standoff, he says, investors should look for higher yields. In particular, the stocks of large companies are paying investors an average of 2 percent annually, and high-yield corporate bonds are paying an average of 7.26 percent.
