Investors: How to Deal With the Debt Ceiling Debacle

In the midst of the debt ceiling debate, what's an investor to do?

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Most investors are watching the debt ceiling debate with uneasy awareness of the risk to global financial stability if a compromise isn't reached in time. But, few investors have a true plan to respond to the possible outcomes of this situation.

In conceptual terms, the problem is simple: The U.S. government has been spending more money than it collects for many years, so we've accumulated a huge national debt. In an effort to control the amount of deficit spending, Congress has passed laws limiting the amount of debt the government can carry. Depending on who you ask, we are projected to exceed the current limit or "ceiling" on August 2. If an agreement to expand this debt ceiling or cut spending is not reached by that time, the government will no longer be able to meet all of its debt obligations.

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There are several proposed solutions to address this problem. The answer is not as simple as "expand the ceiling, cut spending, or both." Here are four of the most likely outcomes:

Best case. A "grand deal" is reached ahead of the deadline, the short-term borrowing limit is addressed, and long-term budget deficits are brought under control. Some nuances exist regarding whether this deal involves more spending cuts or tax increases, but this is essentially good for global stock and bond markets, commodities, and especially for U.S. government bond holders.

Delay case. A short-term solution is created for the current borrowing limit, but no long-term resolution is achieved. This scenario creates minimal impact for markets in the near term, but simply delays the eventual outcome of the situation, with future potential calamity for the markets and economy.

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Managed default case. A short-term solution is achieved (most likely by the Treasury Department) by deciding to pay some obligations of the U.S. government. This could result in U.S. Treasuries continuing to be paid all interest and principal payments, with only service providers or beneficiaries (such as employees or Social Security recipients) being delayed payment. This scenario is likely to have some short-term impact on financial markets. Global stock markets may also take a hit as a result of the ensuing uncertainty.

Worst case. If even one U.S. Treasury bill, note, or bond is not paid on-time, in full, the situation could be disastrous. Due to the virtually "risk-free" status of U.S. Treasuries in modern financial modeling and markets, a default could create immediate panic across the global financial system. A new recession in the U.S. economy would be likely, and global stock markets could fall to new lows.

This is a challenging environment for any investor. Given the wide range of possible outcomes, it is dangerous to take too aggressive a stance in either direction. So, what's an investor to do? Now may be the time to reallocate some proportion of your portfolio to cash or hedge your portfolio using inverse strategies.

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This begs the question: "How much risk should I remove from my portfolio?"

Many investors have never even considered this question, but it is essential to take the time to understand their true risk budget. This generally begins within the context of an overall financial plan, beginning with an expense budget.

Creating an expense budget is a tedious task, so recognize that while precision is important, accuracy is paramount. However, with a defined (even if it's not detailed) budget, you should be able to determine your non-negotiable expenses—typically food, clothing, shelter, and health care—and those that can be more flexible, such as travel, luxury goods, and big-ticket items. Once you define your basic or "survival" budget, you can set aside an appropriate amount for an emergency fund. You should also have a general idea of how much capital you have to devote to investing in more risky assets.

Within in this context, you can easily determine how much risk you are capable of accepting in your portfolio. Notice that I haven't mentioned your "tolerance" or "comfort" for accepting risk, but offered a more defined and analytical approach to measuring the risk you can afford to take. With your risk budget in place, you can more effectively handle uncertain situations, such as the debt ceiling debate.

As with any major market event, it's important to view a potential "crisis" with an eye toward the opportunities it may create rather than being blinded by fear.

Timothy R. Lee , CFP®, is a managing director and cofounder of Monument Wealth Management in Alexandria, Va., a full-service investment and wealth management firm. Monument Wealth Management is backed by LPL Financial, an independent broker-dealer and Registered Investment Advisor, member FINRA/SIPC. Monument Wealth Management has been featured in several national media sources over the past several years. Follow Tim and Monument Wealth Management on their blog Off The Wall , on Twitter at @MonumentWealth, and on their Facebook page. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results. Strategies involving asset allocation and diversification do not ensure a profit or protect against a loss.