Stepping Back from the Fiscal Cliff

“Put down the mouse; move away from the computer and no-one will get hurt.”

This is my advice to all those who have traded in natural disasters for man-made disasters as THE thing to be worrying about these days.  I am referring specifically to the “fiscal cliff” which seems to be depressing stock markets, energizing financial pundits, and sending consumers into a tailspin, ready to take drastic action. My job, as a CFP® professional, is to reach out to as many consumers as possible, to talk them off their own financial cliffs.  In other words, we need to get things into perspective and take a step back from the precipice.

For all you media-proofed readers, the fiscal cliff – a term popularized by Fed Reserve chairman Bernanke – refers to a possible convergence of events in 2012 that could prove expensive for US taxpayers and negative for economic growth.  Barring congressional action, tax rates on ordinary income, investment income, and estates are scheduled to rise for virtually all working Americans in January 2013, while significant cuts are slated for government spending.  Then there is imposition of additional taxes on investments for wealthy Americans that will come into effect in 2013 as part of Obamacare.  Last but not least, unless a “patch” is created by the end of the year for the Alternative Minimum Tax, many middle-income Americans will get socked with having to pay the alternative minimum tax (which by definition is higher than the regular tax) in April.

Sound scary? According to the Congressional Budget Office, if all these events happen, it’s enough to scare off 2.9 percent from our annual GDP growth during the first half of next year.  Given that our current growth rate is about 1.7 percent annually, that means we would dip into negative growth territory.  This, in lay terms, would mean recession.

So what’s a frightened investor to do? One possibility is to move quickly for the rest of 2012 and take advantage of current tax rates while there is still time.  This would mean selling all appreciated stocks to lock in capital gains at 15%, selling all dividend stocks to avoid next year’s higher taxes on investment income, and using the proceeds to go to cash or bonds.  And if you have high net worth well over $1 million, you might make large gifts to family members to get wealth out of your estate and thereby avoid the prospect of higher estate and gift taxes next year.

This is certainly what our animal friend – the lemming – would do.  He would follow the crowd (also known as the financial markets) off the cliff, come what may.  Currently this crowd is dumping stocks, and scurrying to government and municipal bonds.  But unfortunately, a lemming is apt to die once he goes over the cliff, and while the American consumer is unlikely to meet as dire an end, he still stands a good chance of not being able to recover from the jump.

Before you, too, leap off the ledge, listen to me.  I am standing down below, because, as a CFP® professional doing her job, I will be on the ground dealing with the fallout.  So here I am, megaphone in hand, and this is what I want you to hear:

  • Tomorrow’s disasters ALWAYS loom larger and seem far more dire than yesterday’s.  Perception, however, is not reality.  The “cliff” is far from a 100% certainty.  Some credible forecasters put the probability at less than 30%.
  • Markets, like our teen-aged kids, over-react in the short-term. It’s when we over-react to the over-reaction that gets us into big trouble.
  • Suppose you do land safely, in a cozy bunker of 0% cash, bottled water, and canned goods.  When do you re-emerge and get on with the long-term work of wealth building?  It has been my experience that those who suffer most from market disasters are the investors who get completely out and never know when to get back in.

And, if the worst does indeed happen, wouldn’t it make sense to pack a parachute?  This might look like setting aside some more cash in your emergency fund, re-balancing your portfolio back to your original long-term allocation, and talking with a competent professional about smart strategies to manage spending, debt, and even your human capital (i.e., your ability to work and earn income) in difficult times.

In other words, an all-or-nothing response seems totally uncalled for.  Some say it was the extremes of all-or-nothing thinking that created the fiscal cliff in the first place, so it’s unlikely that the same approach will get you down safely.

And if you really can’t live without a dramatic disaster to worry about, may I suggest you focus instead on December 21st, when according to the Mayans, the world will end?  Who cares about tax rates when we won’t even get to celebrate the holidays?

 

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