Before the Sky Falls: How to Prepare for a Greek Default

There are things you can do to prepare for a Greek default—but should you?

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If Greece is a Black Swan, it's a slow one. Black Swans, you may recall, are Nassim Taleb's famous metaphor for extreme, unforeseeable events that can have nasty implications for financial portfolios and much else. Whatever the fallout from a Greek default, however, the event itself won't be a bolt from the blue. So if you're looking to protect your portfolio, there's time to prepare.

But how, exactly? Professional investors have several suggestions, some of them more feasible than others for retail investors working with publicly available mutual funds and ETFs:

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Sit tight. The simplest response is to do nothing. Active investors might find inaction hard to swallow, but action is often a more costly choice. For one thing, lots of the worry about Greece is already priced into the market, and those who sell now could make the classic mistake of doing the exact wrong thing at the exact wrong time.

"I think a lot of investors are likely better off letting things unfold by being aware of the effect that [the situation] has on their portfolio," says Jeff Tjornehoj, head of Americas research for Lipper, the financial-data provider. Investors should monitor the situation, he says, "but not be panicked by it. The worst time to make a change is at the bottom of a market."

The best protection against extreme events remains "good old asset allocation," says Vassilis Dagiouglu, head of asset allocation for Mellon Capital Management. "Prices already reflect a lot of the bad news," he says. "There may be more downside, but as long as you maintain your equity and your fixed-income [allocations], generally, that will help you navigate through these markets."

Fixed income. If you do decide to act, the most obvious—and perhaps easiest—approach is to minimize equities and maximize fixed-income assets. Lots of folks are moving in that direction. According to IndexUniverse, a website that focuses on ETFs and index funds, fixed-income vehicles in May comprised seven of the top 10 ETFs in terms of net inflows. (The S&P 500 fell 6.3 percent that month, largely on concerns about what will happen in Europe.)

At the top of the list was the Vanguard Total Bond Market ETF Fund (BND), raking in $1.23 billion and putting its assets at just over $17 billion—the third-largest bond ETF by assets under management. Close behind was the iShares Barclays 1-3 Year Treasury Bond Fund (SHY), which took in a net $1.15 billion. Those two funds alone accounted for about a third of May's $7.46 billion in total flows into U.S. bond ETFs.

[See Should You Have ETFs in Your Portfolio?]

PIMCO's Total Return ETF (BOND), which launched only in March, has gathered $1.3 billion—a record haul by an actively managed ETF. Although it was designed to track PIMCO's $260 billion Total Return mutual fund (PTTRX), it has outperformed the larger fund by a factor of four (4.97 percent vs. 1.26 percent). One reason: The ETF is much smaller, so it represents what Morningstar ETF analyst Paul Justice calls a "high-conviction pick list" of about 400 positions, compared with the mutual fund's 18,400.

Of course, bonds carry risk, too. If nothing else, there is a significant long-term opportunity cost to being out of equities. There's also interest-rate risk—the danger that rates will rise, as they inevitably will from current historical lows. Rising rates generally hurt the prices of outstanding bonds. Lastly, there's inflation risk: If the economy improves and prices start rising, the real return on bonds will fall.

Some might argue that people nearing retirement should be concerned enough about Europe to substantially boost their fixed-income holdings. But if you're, say, 50 years old, fixed-income assets should already represent maybe half of your holdings. "Trying to time changes in asset allocation is quite challenging," says Mr. Dagiouglu. "I would advise maintaining the current allocation … and not really trying to time when they should be buying or selling bonds."