How to play the great European "What if?"
Most of what I've been reading and hearing tells me that there is about a 50/50 chance that:
A) Europe finds a way to muddle through, in which case stocks keep going up.
B) Europe implodes and stocks tank.
If A, then you want to be fully invested in equities or you'll miss the better part of the rally by the time you get back in.
If B, then you should sell now (if you haven't already) and have a lot of extra cash on hand so you can bottom feed later.
Since no one really knows (including those on both sides who say they know), what's an investor to do?
I sold a lot of stocks in early November and was cash-heavy for about six weeks (50% cash) just because I felt pretty sure things were about to implode and the cash enabled me to sleep better. At 50-50 I was in place to participate in any rally to an extent and be ready to buy if things went sour. It was the right move for me, psychologically.
Around Christmas, when stocks were rallying, I went back to my normal "fully invested" (for me) 70-30 (70% equities, 30% other) and I'm glad I did. That's where I'm staying and here's why I am and why I can sleep at night even though Europe is still a 50/50 proposition.
If alternative (A) occurs, I think we'll be in for a long-term bull market. We've been in a long-term bear market since '99. Sometime in the next few years, maybe now, maybe later, the normal 14-17 year circadian rhythm is due to shift back. (Unless this is The End Of The World As We Know It, in which case it really doesn't matter what you do).
If (B) occurs, there are three sub-sets:
1) A crash, followed by a relatively rapid recovery and bull market
2) A crash, followed by 2-4 years of muddling along like we have been since '99, then a new bull market.
3) A crash, followed by depression, wars, famine and TEOTWAWKI.
Since no one really knows, let's assume that each of those outcomes has equal odds (1 in 3) of occurring.
Now, combined with option A, we have a 2/3 chance of stocks being higher by the end of 2013 (A or B1), a 5/6 chance of stocks being higher by 2017 or so (A or B1 or B2) and a 1/6 chance of TEOTWAWKI (B3).
Unless you are confident in your supernatural ability to call a bottom when it occurs, or you have a time frame shorter than 5 years, your best bet is to stick with a highly diversified portfolio heavy on equities and ride out the storm. I haven't talked to him today, but I'd guess (based on his behavior) that Mr. Buffett's view on this is not too different from my own.
And when you think about risk, think about this: Most individual investors miss most rallies. That's a risk too.