Earlier this year, the U.S. hit its $31.4 trillion (yes, trillion with a "t") debt ceiling, sending the U.S. government into a scramble to fix the issue for the time being. For some people, this was the first time they've dived into the debt ceiling issue. But regardless of where you personally stand, it's important to remember to control what you can control.
What is the debt ceiling?
Established in 1917, the debt ceiling is the maximum amount the federal U.S. government can legally borrow. Congress sets this amount, giving it control over how much debt the U.S. can (and should) accumulate.
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As with businesses and everyday people, there can be a gap between what the government makes versus what it spends. When the government's costs exceed its revenue, the Treasury borrows money to make up the difference, adding to the national debt.
Once the government hits the debt ceiling, it can't fund its daily operations. This includes salaries for federal workers, bills, Medicare, Social Security, veteran benefits, and many other things people rely on for their livelihood. It's essentially like the government running out of money, causing a "government shutdown."
During government shutdowns, federal agencies must discontinue all non-essential functions until new funding legislation is passed and signed into law.
How the debt ceiling affects investors
Debt ceiling issues and the surrounding debates are nothing new, but that doesn't make them any less nerve-wracking when they happen. As an investor, you can view the effects of this directly and indirectly.
Directly, and in an extreme case, the U.S. defaulting on its debt would put into question the security of U.S. Treasury bonds -- largely considered the world's safest investment. Take 2011, for example, when a close call with the U.S. defaulting caused Standard & Poor's to downgrade the U.S.'s AAA credit rating for the first time ever.
Indirectly, the stock market generally experiences increased volatility as news and attention surrounding the debt ceiling cause investors to make short-term moves based on their positions on the matter.
Investors who don't believe the issue will resolve may take a bearish outlook and begin selling stocks. Investors who focus more on U.S. fundamentals and think pessimism is unwarranted may use this time to buy stocks trading at a value.
It's important to stick to the course
Despite all the bad things that could happen with the U.S. hitting the debt ceiling and potentially defaulting on its debts, it's worth noting that the U.S. has never defaulted on its debts. You could argue that there are a few asterisks -- like 1933, when President Roosevelt refused to repay Treasury bondholders with gold (as agreed to when they were sold) -- but for the sake of debt crises, as we know them today, the point generally stands.
That doesn't mean it won't ever happen, but the odds favor it not occurring.
What you don't want to do is make short-sighted moves based on what you think will happen, because that's teetering on the line of trying to time the market. Nobody knows for certain how the stock market will behave in the short term, and believing you do often does more harm than good.
Investors should stick to the course instead of trying to time the market. Your primary concern should be the long-term outlook of economic growth and corporate earnings, not short-term price fluctuations. That applies to debt ceiling issues and investing in general.
The importance of diversification
Diversification is commonly preached in investing, and rightly so. It's more of a must than a suggestion, helping reduce some risks that come with focusing on too few companies, sectors, or geographic locations. Part of having a well-diversified portfolio is investing in companies and bonds outside of the U.S.
Investors overly concentrated in U.S. bonds or sectors sensitive to government spending should consider spreading their investments across a wider range of asset classes, including international stocks, bonds, and perhaps alternatives like real estate or commodities.
Remember: You can't control the outcome(s) of the debt ceiling. Sorry to break that news to you. However, you can control how you prepare your portfolio and respond. By sticking to a disciplined investment plan and focusing on your long-term financial goals, you can better navigate the periods of uncertainty (and chaos) that debt ceiling debates often bring.
Control what you can control.
