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Economic Forecasts

How to Disaster-Proof Your Portfolio In Case of U.S. Debt Default

Investors need to diversify broadly and plan for long-term goals, no matter what the politicians do about the debt ceiling.

The inability of legislators and the Obama administration to agree on a plan that would allow the U.S. to avoid defaulting on its debt underscores an unsettling truth: Every portfolio needs a little disaster-proofing. And that does not mean throwing all of your money into so-called safe havens, such as gold, whenever the investment markets turn scary.

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After all, the go-to safe haven for years has been U.S. Treasury securities -- the very investment at risk of default if Congress does not enact legislation raising the debt ceiling by early August. Default remains a long shot, either in the next couple of weeks or over the next few years. But if the Treasury did default, experts believe, the repercussions would be wide-ranging. Bond values would fall; stock prices would plunge; and even money market funds could be at risk because they’re loaded with short-term Treasury and government-agency IOUs. “There is no safe place to hide in this one,” says Hugh Johnson, chief investment officer of Hugh Johnson Advisors, an Albany, N.Y., investment firm with $2 billion under management.

But there’s a flip side to every economic Armageddon: When bond values fall, yields rise, increasing their attractiveness for income-hungry investors. When stock prices plunge, dividend yields can become downright mouthwatering. When the dollar gets hit, gold and foreign currencies become comparatively more valuable.

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The moral of this story? Diversify. And keep some powder dry -- in other words, have some cash available to handle whatever happens.

That should allow you to both limit your losses and take advantage of the opportunities that volatile markets create. “This is a reminder that some of the basic principles of investing are worth following,” Johnson says. “You need to diversify among asset classes -- stocks, bonds and cash. Diversify among investments in different countries -- U.S., Europe, Asia and Latin America. Diversify your stock holdings among different industries. And diversify your bond portfolio between government and corporate bonds.”

Thomas Atteberry, manager of the FPA New Income fund, says his only caveat to the message of broad diversification is that long-term bonds are not providing yields high enough to offset the risks the bonds present. In today’s environment, he’d keep bond maturities short and hold on to more cash and dividend-paying stocks than usual.

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Crushing debt burdens in the U.S. and throughout much of Europe create an uncertain environment, he adds. “It gets difficult to commit capital with any real comfort,” he says. “Investors need to sit back and think long term.”

What about gold? The metal, which is often considered a hedge against inflation and a falling dollar, is selling at record highs. The last time it rose this far and fast, in the late 1970s and 1980s, it spent the subsequent 20 years falling back to earth, says Kate Warne, market strategist with the Edward Jones brokerage firm. There's no saying what gold will do now, but it also hasn't proven to be the efficient hedge against bad markets that its backers suggest it is. Warne thinks that because of gold’s lofty price, it's a particularly bad time to be buying it now.

On a long-term basis, what matters most is that your investments suit your goals, says Warne. That should allow you to stay calm -- and invested -- even when the markets are not. “What’s worked in the past is to have a diversified portfolio of stocks and bonds and remain invested,” she says. “What you do with your own portfolio in the long term is going to matter a lot more than what the politicians do short term.”

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