We've been hearing a lot about an impending fiscal cliff in the United States. It may seem remote, but if politicians in the U.S. do not reach a budget deal before the end of the year, the fallout could ripple through global markets and eventually our investment portfolios.
Washington has essentially set two time bombs under the world's largest economy that will simultaneously trigger massive government spending cuts and tax hikes.
Think of that final scene in the movie Thelma and Louise when the renegade duo rocket their vintage Thunderbird over a cliff. Now imagine everything you've saved and invested in the trunk.
As the deadline approaches, and politicians bicker back and forth, markets will likely hang on every word. There's not much we can do about that, but there are ways to avoid or ease the plunge.
1. Buckle up with stop losses
Stop losses are always a good idea but with the fiscal cliff approaching they can provide a way to limit losses and lock in any gains your investments make along the way. A stop loss is set at a price just below the purchase price of a stock and triggers a sell if the stock falls to that level. For example, if a stock purchased at $10 has a stop loss set at $8, losses will be capped at $2 a share.
Stop loss strategies vary but one effective way to lock in gains is by setting a trailing stop loss that advances with the price of the stock.
Where you set the stop loss depends on the stock itself. If it is set too close to the purchase price any market volatility not related to the individual stock could trigger an unwanted sell — and unwanted trading fees. As a rule-of-thumb some professional traders set stop losses at ten percent below the purchase price or lower for more volatile stocks.
The best thing about stop losses is that they are most often included in the cost of the trade, so there's nothing to lose.
2. Move into the slow lane with blue-chip stocks and bonds
If your investment portfolio runs the risk of going over the cliff it's good to have holdings with a cushion and the ability to bounce back. Blue-chip dividend paying stocks and bonds can provide that resilience.
History shows shares in mature companies with solid earnings tend to suffer less than the broader markets, and recover their value quicker. Established companies with solid earnings also tend to pay higher and more consistent dividends, so the investor gets paid the same amount while waiting for the stock to recover.
Few investments offer a better cushion from a market shock than bonds. Sure, yields on government bonds are a joke but a 1 per cent gain on a bond does wonders in softening the blow from a 10 per cent drop in a stock.
Investors who can take on a little more risk and still want the cushion from bonds can get higher returns from corporate bonds issued by those same blue-chip companies with solid earnings.
3. Slam on the brakes and get off the road
If the cliff on the horizon is a little too much for you, consider selling those riskier assets and putting your money into something that won't be impacted by a dramatic drop. Guaranteed Investment Certificates (GICs) can pay about 2 per cent annually and — as the name implies — the principal and interest are guaranteed.
Money market funds generally pay out less but, unlike GICs that mature, investors can sell any time — like when that fiscal cliff is in the rear view mirror.