US to be downgraded: Hold my 401k and mutual funds or sell?

Back to the mailbox for another reader question, this one is an excellent one from Steve.

Steve wrote:

Just wanted to touch base. My father was a depression era kid prior to WWII. Nine years old and the man of the house, since his dad died young. Regardless, his mind-set shaped me, and now here we are, once again, in a pre-depression. So now I am trying to figure it all out. I have only mortgage debt, that’s it. I expect to pay it down in two years.

Any other advice you can push my way would be helpful, but one question. Since the “Debt Ceiling” will now be advanced, what is a safer bet to invest in? Gold, Silver, Food, Francs? Any help would be appreciated. I have 83K of invested capitol I don’t want to lose it to these turn of events. It is largely in mutual funds and a 401K. I have four mouths to feed as well, so I am hoping to set them up as well with the education to get through this.

Thank you,

Steve

Steve, thanks for sharing your story and for your question, I’ll do my best to answer it.

Your question seems to be centered around the potential that the US may see our AAA credit rating downgraded by ratings agencies such as Moody’s and S&P as a result of the recent passage of the new debt ceiling, so what impact will that have on your current investments that are in US dollars? Furthermore, you’re wanting to know what to do with your existing holdings in your 401k and outside mutual funds. Should you hold, sell and buy gold, buy foreign currency, or what? I’ll try and answer your question to the best of my ability, as I think it’s a great question.

Although there’s no clear answer to your question, because this is unexpected territory for the US, we can learn from the experiences of other countries and make assumptions as to best position ourselves to mitigate and minimize losses. However, I first must make clear that the underlying answer to your question should come back to your investment or retirement plan. For as long as the market has been around there has been numerous swings and ups and downs within each decade, it’s your investment plan that matters.

Having said that, I’ll make some assumptions about you and your situation to the lay the foundation for my answer: I’m going to guess you’re in your 50’s (you’ve told me that you’ve got four kids also – congrats and sorry, I feel your pain) and I’m willing to bet you’re wanting to retire in the next 10-15 years. This means, you’re moving into the asset preservation time of your life when you want to hold on to the nearly 100k you’ve accumulated over the years, pay off the last of your mortgage, grow what you have without risking any losses, and grow and invest additional money to build your retirement funds. Ultimately, you need to have an age in mind that you believe you’re going to stop working at, and how much money you’ll need to live for 20 or more years. Let’s just say you want to retire at 65, and you’re going to live until 85. You need 20 years of funds. Assess how much you’ll need to have in the bank at 65 to be able to do that, I’ve got a retirement calculator that can help you. If you’re looking at unrealistic numbers, then you’re going to have to change your assumptions – and either have less at retirement or retire later. That’s very simplistic, and you may already know it, but I wanted to point that out before I moved on with answering your question. I also wanted to make the point surrounding your children’s education, don’t worry about their higher education until you’ve got your retirement covered, they can borrow for school, you can’t borrow for retirement.

On to the debt ceiling question, so what would happen to your current holdings if you did nothing else and left them right where they’re at? With little question your portfolio would lose money (from 5- 30%), as many investors would sell and others would rebalance to adjust and move out of riskier equities as a result of the increase in riskier treasuries. In addition, mutual funds own around 5-10% of US treasuries, thus you would see a drop in value in those funds as well as many are forced to sell. What would happen to bonds? There’s the potential that some pension funds and foreign countries could sell off, lowering their value, but an equal potential that bonds could in fact increase in value as more investors seek to buy at lowered prices. It makes sense to know who owns treasuries, and understand that not all treasuries can and will be sold if there’s a downgrade. The federal reserve owns about 15% and won’t be sellers, while foreign countries own nearly 50% of US treasuries, and they likely won’t sell as their are few other less risky places to be. There’s the potential that they would sell US and buy German bonds, as they may be deemed slightly less risky. Overall, the impact to credit for businesses and individuals alike would certainly affect equities in a negative manner for a couple of years at minimum, similar to what we saw just a couple of years ago. Remember how the banks quit lending? Investments in these industries (banking and financials) would be negatively affected as well.

So what can or should you do to hedge against this possibility? Diversify internationally (you already should be). As mentioned, I would look into German bond funds as a relatively safe investment. As far as gold is concerned, I personally would stay the heck away as I believe it’s far over-valued. Personally, I look for investments that I believe are currently undervalued, and I believe real estate in many areas to be just that. Don’t get me wrong, in many areas real estate may be over valued still, however, in my local area, there’s ton’s of deals to be made and many of these could be great rental properties which in turn are income generating investments just like any other investment. If there’s another credit crunch and further spikes in unemployment, there’s going to be a huge demand for rental properties. With regards to commodities as an investment, it’s worth looking into as equities go down, commodities typically go up, but you better know what you’re doing and I’m guessing you don’t – so stay away.

Personally, I’m sitting tight after I pulled out of equities completely when the market hit 12,800 around the end of April, and I put all of my investments in money market funds. There’s risk there too, but compared to the risk in equities, I feel safer. Seeing that the Dow is now is down to 11,646 as I write this, I feel like I’ve made the right move. Good luck!

Tim Harford, an economist and author, said:

Gold is a tricky one, and here’s why. … bubbles should be defined in terms of fundamental values. For the price of corporate stock, we should be looking at future profits, and you need to make your best judgment for what that should be. But … it’s just not clear what the fundamental value of gold is. It’s worth something because people have always thought it’s worth something. And that’s really weird, because what it tells you is gold is in a 4,000-year-old bubble. And if it’s lasted 4,000 years, maybe it will last another 4,000 years. Who am I to say?


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