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A 401(k) and the risk of default

Chris Farrell Jul 26, 2011

Question: My husband and I were discussing the potential government default looming ahead. What is your advice on what to do with a 401K? Some people I work with want to sell everything in their 401K’s and keep all their money in cash until this whole thing is sorted out. This seems drastic to me but then our country has never defaulted before. Others just want to hang tight and not do anything. That is my gut feeling. My husband wants to do something but is not sure what a safe haven would be. I have not really seen any discussion on how a default would affect the stock market. What are your thoughts on this? Catherine, Tallahassee FL

Answer: What’s going on? Thanks to the financial vision of Alexander Hamilton, America’s first Treasury Secretary, the government of the world’s wealthiest nation has always paid its debt obligations. It’s why every investing primer published by mutual fund companies, investment textbooks, and popular personal finance guides such as Burton Malkiel’s A Random Walk Down Wall Street describe U.S. Treasuries as the default-free investment.

Yet Washington is seriously debating defaulting on the federal government’s debt. It’s a sad moment in U.S. history that we are even taking questions like yours. Washington is taking fiscal irresponsibility to new levels, threatening to raise the unemployment rate, send the economy spiraling lower, and calling into question the full faith and credit of the federal government.

How would an actual default affect the average American? Since this is uncharted territory in the U.S. every scenario comes with caveats such as possibly, likely, probably and, most honestly, we don’t know. But the bottom line of default on workers and their families is summarized in a chilling word: Catastrophe.

Odds are extremely high that default won’t happen. But what should you do in the meantime? After all, few expected that Washington would get this far into fiscal irresponsibility.

First, the time-honored tactic of diversification remains one of the more powerful ways to protect finances from the downside. Diversification won’t provide much shelter in the short-run when almost everything cascades sharply lower during a moment of panic. The power of diversification reasserts itself within a reasonable period of time, however. Diversification has worked throughout our turbulent financial history.

Second, putting money into FDIC insured accounts and the like is a relatively cheap and easy way to hedge against catastrophe. If you’re worried you could lower the risk of your overall portfolio by increasing the amount held in cash and reduce investments in stocks and bonds. The price will be a lower return (well, actually a zero return) on the cash portion of your portfolio since you’re making almost nothing in yield on the money.

That said, I’m in your camp. This is one of those times when staying the course with your 401(k) asset allocation is probably the right decision for many workers, especially if they’re young or middle-aged. I think most workers have become more conservative with their portfolios with all the turmoil, shocks, and disappointment of the past 5 years.

Here’s a simple test that I like: The J.P. Morgan standard. The tale goes that a man was in a panic after putting all his money into the stock market. He wanted to be rich, but if the stock market crashed he was financially ruined. He couldn’t sleep. One day, seeing the imposing figure of Morgan–the great 19th century financier–on a street, he summoned up his courage, and asked, “Mr. Morgan, I’ve investing all my money in the stock market and I can’t sleep. I’m a wreck. What should I do?” Morgan replied, “Sell down to the sleeping point.”

Question is, what is your sleeping point? I would stay the course if you still like your current asset allocation. If you’re too nervous for that, hike the amount of cash in the portfolio to the your sleeping point.

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