What Should Long-term Investors Do About the Fiscal Cliff?

All eyes are on the potential impacts of the so-called "Fiscal Cliff," the combination of expiring tax cuts and mandatory spending cuts that will automatically kick in by the end of the year if Republicans and Democrats are unable to reach a new budget deal. With much uncertainty remaining as to the outcome of those negotiations, anxiety is rising with investors about what the impacts may be if a deal is not reached and what, if anything, they should do in response.

Before we examine the question of what to do, let's first examine the three scenarios that could emerge from the talks in Washington on the Fiscal Cliff:

Scenario A: The Grand Bargain
In the best-case scenario for the markets, Republicans and Democrats reach the elusive "Grand Bargain," a large-scale political compromise that addresses the big picture issues of tax reform, debt reduction and entitlement reform. Such a deal would remove much of the uncertainty that has hung over the economic landscape for the past several years.

Though politically challenging, this scenario is not entirely implausible; the bi-partisan Bowles-Simpson commission proposed such a compromise in 2010 and that proposal is thought to be the likely starting point for any large-scale budget deal that emerges from the Fiscal Cliff negotiations. Still, many partisans on both sides of the aisle object to such a deal, which may make reaching a Grand Bargain politically difficult in the narrow window of time left before the Fiscal Cliff kicks in.

Scenario B: Kick the Can
Perhaps the most likely scenario in the near term is a stop-gap agreement between Congress and President Obama that blunts the impacts of the Fiscal Cliff and gives the parties breathing room to hopefully reach a larger-scale agreement in 2013. Although such a deal would do nothing to solve this country's pressing long-term fiscal problems, it may be the most practical solution available to politicians to avoid the Fiscal Cliff given they only have six weeks in which to reach an agreement.

Scenario C: Over the Cliff
If the political parties fail to reach a compromise and no action is taken, then the impacts of the Fiscal Cliff would kick in, including the expiration of the Bush tax cuts and arbitrary budget cuts totaling $600 billion. Economists generally agree that allowing the Fiscal Cliff to kick in would likely send the economy into recession into 2013.

Investor concerns about the Fiscal Cliff are focused on worst-case scenarios. While most pundits seem to believe at least a short-term solution will be reached to avoid the Fiscal Cliff, let's assume for the sake of discussion that no such solution is reached and the economy tilts into recession in the early part of 2013. What should investors do if such a scenario seems likely?

At the risk of over-simplifying, there really are only two possible paths investors can take in advance of any perceived short-term risk to the market: Stay the course and focus on the long term, or make short-term changes to your portfolio to try and avoid the perceived risks.

Investors who stay the course assume the risk that the worst-case scenario comes to pass; in this case, a recession that would likely knock stock values down for a period of time. Yet while having to endure an otherwise avoidable recession would be frustrating, from a long-term perspective it would nonetheless be a typical part of the economic cycle. Since the 1930s, the U.S. economy has experienced a recession on average every 3 to 5 years; in fact, the 10-year gap between recessions from 1991 to 2001 was the longest recession-free span in our history. And history shows that well-diversified investors who stayed the course have always been rewarded for their discipline, with stock market values typically recovering well in advance of the recession's end.

Investors who succumb to the temptation to make short-term changes to their portfolios also incur considerable risks. While a flight to less volatile investments to avoid the anticipated trouble may make an investor feel better in the short term, such moves require the investor to be right twice - once on the way out of the market and again on the way back in. Given that the market rarely reacts to events in a predictable manner, guessing right twice, let alone once, is a hard feat to accomplish.

We don't have to look back in time too far to see a real-world illustration of this. In the summer of 2011, Democrats and Republicans were in a stalemate over raising the US debt ceiling, and the once-unthinkable notion of a US credit default suddenly became thinkable. Volatility plagued the stock market for weeks in July, and investors breathed a sigh of relief when a deal was reached to raise the debt ceiling at the 11th hour in early August. Then, unexpectedly, Standard and Poors downgraded the US credit rating, and stocks plunged rapidly, declining nearly 18% over the next eight weeks:

In the initial days after stocks began plunging, thousands of panicked investors fled the market for the perceived safety of bonds and cash. Though many of these investors waited only a few days to react, they caught much of the initial downturn, locking in deep losses when they sold.

Then, just as unexpectedly, stocks staged a dramatic resurgence beginning in October. Over the next few months, stocks recovered all the summer's losses, soaring nearly 20% percent by the end of 2011:

Investors who stayed put in the face of the "obvious" troubles that were on the horizon in July had to endure a bout of volatility, but all told their portfolio values were back where they started in just a few months' time. Meanwhile, most of those who reacted to the volatility by bailing out of the market failed to avoid the earliest, steepest part of the plunge, and also failed to get back in the market for the earliest, steepest part of the recovery. Such investors typically locked in double-digit losses in their portfolios as a result.

Long-Term Perspective

When it comes to investing, the phrase "long-term" gets thrown around so often that it becomes clichéd and loses its meaning. And yet it is a phrase worth re-examining.

Over the entire history of the stock market, there has never been a twenty-year period of time when stocks lost money, and there have only been a few ten-year periods (one of which concluded in 2011). So while we lurch from crisis to crisis in the short-term, over the long term stocks respond reliably to the never-ending innovations that constantly improve the world in which we live. Even this week came news that the U.S. will surpass Saudi Arabia by 2020 as the world's largest oil producer. Who could have anticipated such a turn of events even ten years ago?

No doubt the media will be in full-frenzy for the remainder of the year, breathlessly reporting every twist and turn in the Fiscal Cliff negotiations. Should those negotiations break down and volatility set in, the media will quickly return to the same catastrophist mindset it had in 2008 and 2011. The temptation for investors in such a situation will be to succumb to their emotions and flee the market.

Resist the temptation, for that is when investors do the real damage to their portfolios.