U.S. Debt Default?
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What happens if the U.S. doesn't raise the debt ceiling and then defaults on its debts? Are our investments in danger? Should we sell?
Let’s dig in a bit.
Setting the stage
Let's start with a few let's-get-these-out-of-the-way's:
I don't have any particularly special insight into whether the U.S. will default.
I don't have any particularly special insight into what would happen if the U.S. does default.
(Gee, thanks so much for your keen insight, Keith Spencer, CFP®.)
But I do have a few thoughts nonetheless, broken into 8 points.
Note that most of the points below can be applied to any crisis that’s going on in the world or markets. This isn’t just about the debt ceiling.
1. Default isn’t a foregone conclusion
I don't think we should consider default as a foregone conclusion. In the past, the government has always found a way to address the debt ceiling, with Congress acting 78 times since 1960 to raise, extend, or revise the debt limit. (Source: U.S. Department of the Treasury)
I don't know if that will happen this time; this time could certainly be different, and there are folks in the government who are saying that they actually want the default to happen.
But I think keeping history in mind is helpful.
2. The stock market has already priced in some risk
I'm not convinced that people can accurately predict, on a consistent basis, what is going to happen in the stock market. This would be true whether we were in danger of government default or not.
Generally speaking, I think the stock and bond markets do a good job of incorporating everyone's expectations as a whole ... that is, if the majority of investors/money think the market will go down, it has probably already gone down and priced in that possibility; and if the majority of investors/money think the market will go up, it has probably already gone up and priced in that possibility.
That is, the market (or, more accurately, the sum total of all the investors) anticipates a future event and the potential ramifications of the event, and reflects all that in the current price.
This, of course, is probably grossly oversimplified, but I think the idea is generally true.
Note though that it doesn't mean the majority of investors/money are correct at any given time, it's just that the market tends to reflect what they are thinking.
But my main point is that we, as individual investors, aren’t good at incorporating the risk of future events better than the market as a whole is. So, therefore, the risk at any given time is already priced in.
3. This has happened before
There is some historical precedent to having a debt ceiling crisis, as we dealt with something similar in 2011, ultimately causing Standard & Poor's to lower the U.S.'s credit rating.
During that time, the S&P 500 (U.S. stocks) went down by about 19%. There was another time in 2013 when the debt ceiling came under pressure, and the S&P 500 fell about 6%. (Source: Reuters)
If the U.S. keeps going down this path, will the stock market do something similar this time? Worse? Better? Don't know.
4. This is a blip compared to the historical trend
Even if the market does go down by 19% (or worse), it's important to keep a historical perspective.
The chart below does a great job of putting this into context. (Source) The world has dealt with crisis after crisis after crisis over the past century, but the market keeps chugging along. So my suggestion would be to not get too caught up in the downsides of any particular crisis.
Note: The 2011 debt ceiling crisis is highlighted in yellow on the right side of the chart below. As you can see, it's just a blip in the overall trend.
5. Bull markets are much more powerful than bear markets
Historically speaking, bear markets (stock markets going down) have been much shorter and less dramatic than bull markets (stock markets going up).
So even if we do dip into recession (whether caused by a debt default or due to other things), it's important to keep this in mind and not panic. See the chart below for a visual representation of this in action. (Source: First Trust)
6. Timing selling AND buying back is crazy difficult
You might be tempted to think it would be good to sell everything now and then buy back in once we get through the debt ceiling situation.
The danger in doing this is that it's extremely hard to do with any degree of success.
The challenge is that you have to make TWO correct decisions, when making just one decision like this is so hard and unlikely to be correct.
The first decision is timing things correctly as to when to sell; the second decision is timing things correctly as to when to buy back in.
7. Missing the best days severely limits your portfolio’s upside
This builds off the previous point. One of the dangers of being out of the market for any amount of time is that you never know when the (really) good days may happen.
Missing out on those good days can be extremely damaging to your long-term returns. And those good days can happen at any time ... even in the middle of a downturn.
Check out this visual showing the cost of missing just a few of the best days. (Source: Dimensional Fund Advisors - animated version with different/updated numbers)
8. Internal factors vs. external factors
When it comes to the decision of how to be invested at any given time of your life, I think it's much better to look at internal factors, rather than external factors. Or in fancy-pants terms, it’s better to look at endogenous factors rather than exogenous factors.
Exogenous (external) factors are outside of your control and/or aren’t affected by decisions that you make. For example, the possibility of a recession, inflation, or a debt ceiling crisis.
Endogenous (internal) factors relate to things within your control and/or are affected by decisions that you make. For example, the stability of your employment, whether others are economically dependent on you (e.g., children), and your emotional tolerance for investment risk.
The idea is to ignore what's happening externally, and instead position your investments according to the various risk factors that are internal and more specific to you.
Conclusion
Add it all up, and I think the most historically-prudent thing to do is just sit tight and stay invested.
In fact, it's probably best to ignore the headlines, as they tend to be much more gloom-and-doom-oriented than history actually turns out to be.
Hang in there and stay the course.