Worried about the Fiscal Cliff: Should I Sell?

What changes do you think investors should make to their portfolios to avoid the financial meltdown that could result if we go over the "fiscal cliff"? -- Mark Anderson, Lawrenceville, Ga.

If you've already set a reasonable investing strategy that reflects your risk tolerance and the length of time your money will be invested, then you probably shouldn't be making any changes -- at least not dramatic ones.

Granted, if we go over the fiscal cliff -- that is, if tax increases and spending cuts kick in at the beginning of next year as currently scheduled -- the economy could take a sizable hit. The Congressional Budget Office has warned that the unemployment rate could rise and the economy could slip into recession.

Should that happen, stock prices could go into tailspin. To avoid getting caught in the carnage, some advisers suggest that investors significantly cut back their stock holdings or move into more defensive shares that hold up better in downturns.

But I think this approach is wrong for a few reasons.

First, if you change course each time there's the possibility of a setback in the market, you're no longer staying true to an investing strategy.

You'll just be reacting in a knee-jerk way to every potential threat that comes along. Indeed, if you had sprung into action every time investment managers and the financial press sounded the alarm, you would have rejiggered your portfolio many times over the past couple of years alone, responding to the U.S. debt ceiling imbroglio, Standard & Poor's downgrading of U.S. Treasuries, the financial crises in Greece and Spain, not to mention the routine prognostications of doom that our fragile economic recovery could fizzle.

Related: Why There’s No Such Thing as Risk-Free Investing

More importantly, the idea that you should revise your investing strategy to protect yourself against some perceived calamity suggests that you know it will take place and how it will unfold.

That's a big assumption. In the case of the fiscal cliff, for example, there are many possible scenarios that could play out, ranging from careening over the cliff to kicking the problem down the road to some sort of compromise on tax hikes and spending cuts.

Even if you could predict what will actually happen, you wouldn't necessarily know what the fallout will be. No investment rises or falls in isolation. Stocks, bonds, Treasury bills, commodities, real estate, foreign securities -- all are valued relative to one another as millions of investors globally make their individual buy-and-sell decisions. Predicting where prices will settle is a dicey business at best.

Finally, it's not as if the fiscal cliff is some obscure issue no one's aware of. It's gotten tons of publicity. Which means that to some extent at least, asset values should already reflect investors' concerns. Any moves you make are essentially trying to outguess the market consensus.

So as I see it, moving out of stocks into cash or bonds or making any other change specifically to protect yourself against the consequences of the looming fiscal cliff isn't so much a rational choice as an emotional decision masquerading as a rational one. Any action you take could work out, or it may not.

Either way, you would then have to figure out what to do afterall the dust settles. Stick with the changes you made? Go back to your old stock-bond allocation? Shift to yet another portfolio mix based on some other potential threat or development? You'd be engaging in little more than an ongoing guessing game.

A better approach: Set an asset allocation strategy and stick to it regardless of whatever issue investors happen to be obsessing over at the moment.

Any money you'll need to tap for emergencies or other purposes over the next couple of years should be in FDIC-insured accounts where it will be immediately available and immune to market downturns. You can divvy up the rest between stocks and bonds based on your risk tolerance and when you'll have to tap into it.

Money you're investing for a retirement that's decades away you can afford to put mostly in stocks and shoot for higher gains, as you'll have plenty of time to rebound from market setbacks. If you're on the verge of retiring or already retired, you'll want more of a buffer against market downturns, which argues for scaling back stocks and emphasizing bonds more.

The point, though, is that you should base your strategy not on shielding yourself from just any single risk like the fiscal cliff. Rather, you want to arrange your portfolio to provide adequate protection from the many different types of threats your portfolio may encounter, while still giving it a chance to grow.

One more thing: Aside from market concerns related to the fiscal cliff, there's also the issue of whether investors should reap gains in their taxable accounts this year since the maximum tax rate on long-term capital gains is scheduled to increase next year from 15% to 20% -- and in the case of very high-income investors, it's supposed to rise as high as 23.8% due to a new Medicare surtax.

If you have long-term gains in investments you're already thinking of selling -- either as part of your regular rebalancing strategy or for other reasons -- then carrying through on those plans before the end of the year makes sense. But I'd be wary of unloading investments with gains just because tax rates might go up, especially if you're planning to hold those investments long-term.

Either way, don't let any selling you do for tax purposes distort the balance and diversity of your portfolio. And if you plan on buying back any securities after selling them for a tax loss, be sure you don't run afoul of the IRS's wash-sale rules.

Bottom line: Until someone develops a crystal ball that will allow investors to truly foretell the future, you're better off building a diversified portfolio of stocks, bonds and cash that can protect you from a variety of risks -- and then resist the impulse to rebuild it every time a new worry comes along.