Debt-limit brink: Can ordinary investors run for cover? Should they?

Don't panic and sell all your investments, but don't have your head in the sand either.

In a nutshell, that's the advice that many financial professionals are giving as the clock ticks down toward either a deficit-cutting accord or a federal gridlock scenario that could mar America's credit rating and shake financial markets.

One reason for that advice is a widespread expectation that, when push comes to shove, politicians will agree on a deal rather than risk the wrath of voters by allowing inaction to foment a financial crisis.

Another reason is that it's not easy to risk-proof a portfolio against something as profound as a breach of confidence in the US dollar and the world's largest economy.

Normally, Treasury bonds are called the haven of safety when other financial instruments are going haywire. But if Democrats and Republicans can't "get to yes" on a plan to raise the current cap on federal borrowing (with a linked plan to reduce future federal deficits), then those very Treasury bonds would immediately come under at least a degree of selling pressure.

Failure to reach a debt deal could also send stock prices down sharply as well, as the Treasury's inability to pay all its bills would translate into less economic activity. Some finance experts say that even money-market mutual funds might be at risk of a rare decline in share value, if confidence in short-term debt markets (including Treasury debts) were shaken.

But the dire scenario is not viewed as the likely one.

"We believe the best course of action is probably to tune out the ever-changing headlines and political rhetoric, and maintain a long-term focus," the investment company Vanguard says in a recent statement to clients on its website. " 'Wait and see' may not be the most satisfying answer to this question [of what to do], but we think it's the right one."

Other financial companies have offered similar advice, warning that investors can often damage their nest eggs when they react to short-term events. In many cases, markets rise as doom scenarios prove unfounded. In others, a dive is followed by a quick rebound, making it notoriously hard for investors to time their moves perfectly.

So is the right course to do nothing?

Maybe a better way to put it is to simply assess your overall financial plan, including a gut-check for how sensitive you are to short-term volatility. Some moves that might make sense for the long-term might also position you for a bit more safety in a US-default scenario.

"It would be better to be in bank deposits rather than money funds," says Greg McBride, a senior financial analyst at Bankrate.com in North Palm Beach, Fla. It's not that money-market mutual funds are likely to drop in value during the weeks ahead, but holding your cash fund in a bank money-market account gives you the added protection of coverage by the Federal Deposit Insurance Corp. (FDIC).

And Mr. McBride says that the best deals at banks include interest rates of about 1 percent, versus essentially zero in most money market mutual funds. So the move could give you some long-term income as well as a bit of short-term peace of mind.

But he warns against stashing all your retirement money in a bank right now.

"The greater danger for individuals is pushing the panic button and selling," McBride says. "You don't want to jeopardize your long-term objectives based on what could be a short -term event."

For investors who feel on edge right now, another comfort can come through diversification, the old adage about not putting all your eggs in one basket. Stock mutual funds may be the core of one's retirement plan, for example, but investment advisers generally caution against having all your money there.

Exposure to non-US markets can also help – but whether the investments are in Europe or China they carry their own risks. Ditto for gold. It is often viewed as a haven from crisis but has risen so much in the past couple of years that some financial analysts warn of a plunge at some point.

For more sophisticated investors, options and futures contracts could be used to hedge against the risk of a sudden fall in the stock market.

Meanwhile, for people concerned that the debt-limit debate is just a symptom of a longer-term decline in the US dollar relative to other currencies, various fixed-income investments are denominated in other currencies. These include mutual funds or exchange-traded funds that invest in overseas bonds, foreign-currency certificates of deposit (Everbank is one provider), or foreign-currency mutual funds such as the Merk Hard Currency Fund.

Amid debate about how safe money-market mutual funds would be in a crisis scenario, some financial companies have issued statements designed to reassure investors.

"We have stress tested our money market mutual funds, and we believe they can withstand significant market volatility – far more than the historical largest one-day move in three-month bills that occurred in the last 40 years," Tim Huyck, a money-market portfolio manager, says in a statement on the website of Fidelity Investments. "If the United States were to be downgraded to AA from its current AAA rating, money market mutual funds would not be forced to sell their government securities."

Separately, Fidelity said it has "response and contingency plans" designed to support customers for all its investment products even in unusual circumstances.
And for all the concern about negatives scenarios, one possibility is that the debt drama ends well – with a "relief rally" as stock investors see a deal put in place and risks receding.

Even an imperfect deal, which fails to close long term deficits, could at least improve America's fiscal position (by reducing those future deficits) and avoid a Treasury default.

"There aren’t many ways Washington can disappoint already low market expectations," economist David Malpass of Encima Global said in an analysis earlier this week. "The only deeply negative scenario is a default on Treasury debt, which all parties say isn't going to happen."