Stocks: How to play the fiscal cliff

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(MoneyWatch) Without Congressional action, up to $600 billion of expiring tax cuts, new taxes, and automatic spending cuts are set to take effect at the end of 2012 or beginning of 2013. If they hit all at once, the impact could amount to as much as 4%-5% of GDP, the equivalent of falling off a "fiscal cliff." Some experts anticipate the economy would experience a significant slowdown and there would be major consequences for financial markets.

Does this worry me? Absolutely! Am I telling my clients to bail from stocks? Absolutely not, though reducing exposure could be prudent, as I'll explain in a bit.

I would argue that there are two reasons investors should not bail on stocks. First, the approaching fiscal cliff is not exactly a secret and thus the possibility is already priced into the market, perhaps partly in last week's decline. Knowing how Congress intends to act would certainly give me a leg up on other investors on playing this fiscal cliff as an opportunity. Unfortunately, I stopped predicting Congress back in 2010 when it let the estate tax expire. Though that was a good year for billionaires to die, it was a not-so-good year for our deficit. These same politicians now appear more concerned with finger-pointing and assigning blame for our debt than working on solutions, so I don't mean to minimize the possibility that they could again put party politics before the nation and sail us right over that fiscal cliff like a hang glider.

Second, the market is a sly old fox that refuses to do what we expect. Conventional wisdom suggests that taking a swan dive off the fiscal cliff would cause stocks to plummet as investors turned to the safety of government bonds. Conventional wisdom, however, is often wrong. Congress voted down TARP on Sept. 29, 2008, and stocks plunged 7% in one day. The next week, it was approved and signed into law and stocks dropped further. In 2011, S&P downgraded US debt and US Treasury bonds soared, making it much cheaper for the U.S. Government to borrow.

But in the face of capricious unpredictability, remember that times of great fear are usually the best times to invest. Fear hit a fevered pitch in March 2009, and those who fled for the exits missed out on the 130 percent return of the U.S. stock market. 

So back to admitting this fiscal cliff has me concerned, very concerned. Okay, fine, it has me scared to death. Regardless, I'm recommending that investors get back to a long-term target stock allocation. Because stocks have had a great four years, I'm having clients sell some stocks to get back to those target allocations. People display a real resistance to selling winners, and sometimes it's hard to get them to act. The fiscal cliff stirs fear and fear can be the instigator to sell enough stock to get to the target allocation. Some might say I'm using the lessons of behavioral finance to manipulate people, and some would be right.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.