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How investors should plan for the "fiscal cliff"

(MoneyWatch) One thing we know for sure about investing is that financial markets hate uncertainty. The greater the perception of uncertainty, the greater the premium investors demand as compensation for taking risk. Rising risk premiums cause bear markets. And if the problems created by the fiscal crisis in the Eurozone weren't enough to cause investors concerns, the potential for falling off our own fiscal cliff surely is.

Investors seem to be hanging on every word from the leading players in the drama, including Rep. John Boehner, Sen. Harry Reid and President Barack Obama. Just in the past few days, the Dow Jones industrial average jumped 200 points after Boehner expressed optimism that a deal on the cliff was in sight, only for stocks to fall when he later said that "no substantive progress" had been made. (Such volatility is something else investors don't like.)

Investors are right to be concerned. Failure to resolve the problem would likely send the markets lower, as the combination of sharp tax increases and severe spending cuts would damage the economy, at least in the short term. That said, there are some important points for you to consider.

Economic dip forecast

According to the Congressional Budget Office's projections, if all of that fiscal tightening occurs real (inflation-adjusted) GDP will drop 0.5 percent in 2013 (as measured by the change from the fourth quarter of 2012 to the fourth quarter of 2013). Growth would likely decline in the first half of the year and rebound at a modest pace in the second half, according to the nonpartisan research arm. So even without a deal by year-end, the economy isn't expected to crater.

Of course, any projections and forecasts should be taken with a grain (if not a pound) of salt. Such forecasts are often off the mark. That's partly due to the inability to fully forecast the responses that governments and markets make to such looming or occurring crises. In other words, if we do go over the cliff, that might be the event that makes Congress act and turns the markets around quickly.

Finally, while no one wants to go over the cliff, doing so might at least be a step toward solving the problems that everyone recognizes -- the U.S. isn't generating enough tax revenue, and we're spending far too much. Unless Congress dramatically changes its political and economic priorities, the current situation with unfunded entitlement programs is simply unsustainable. Obviously, if something can't continue, it'll end, meaning we only have to wonder if it will end well or badly (as the Greeks found out).

All that said, the main question is this: What, if anything, you should you do with this information? Here's how you should think about the problem.

What to do

First, making changes to your long-term plan because of current economic conditions doesn't make sense. If you react to, say, Boehner's comments, you're reacting to something that everyone else knows as well. If everyone else knows it, then that information has already been incorporated into prices. The only thing that truly matters is the overall outcome of the fiscal cliff issue and whether the outcome is better or worse than the market is expecting. The market response will be according to the "odds" that it placed on the specific outcome actually occurring.

For our purposes, let's assume the market thinks the odds are 60 percent in favor of a good outcome. If Congress is able to do a deal, the 60 percent becomes 100 percent, and, all else equal, investors will reduce the risk premium they demand and the market will likely rise, both quickly and sharply. On the other hand, if they fail to come to terms, the 40 percent becomes a certainty and the market will likely fall quickly and sharply.

Here's the bottom line: The losing strategy is to focus on trying to manage returns by forecasting what is unforecastable -- the future. Instead, smart investors know that the winning strategy is to have a well-designed plan that has already incorporated the virtual certainty that there will be bear markets, which can't be accurately forecast. Thus, instead of trying to focus on what they can't control, smart investors focus on the things they actually can control:

  • The amount of risk they take
  • Their diversification
  • Their costs
  • Their tax efficiency

With that said, there are a few actions that seem prudent for you to consider.

Accelerate income. Consider accelerating income into 2012 to take capital gains at current low rates (which will likely rise, possibly even to be the same as the ordinary income tax rate), to avoid the 3.8 percent health care act tax, and to avoid a possible increase in ordinary tax rates.

Avoid estate taxes. Given the high likelihood that there will be at least some reduction in the level at which estates go untaxed (currently $5.12 million), consider actions that will shift assets in a way to avoid the estate tax, such as gifting to children. In addition, it seems likely that the gift tax exemption, currently the same as the estate tax exemption, will be lowered.

Manage deductions. When facing the prospect of higher tax rates, the conventional wisdom is to defer deductions, such as charitable giving, property taxes and your last mortgage interest payment. However, there's now the risk that any tax reform done in 2013 could limit the value of deductions. Thus, the unconventional wisdom might be to accelerate such payments.

Retirement accounts. Given the potential for higher tax rates, you might consider changing your contributions to retirement accounts from a Roth-type election to a traditional-type election in 2013. As always, you should consult your CPA, or other tax advisor, before taking any action.

The bottom line is that if your investment strategy balanced your ability, willingness and need to take risk before Obama's re-election, it should see you through this temporary period of uncertainty. Remember, investing is a long-term proposition -- much longer than one or two presidential terms.

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