"Be Afraid: some in U.S. see shades of 2008 in Euro crisis" -- Rutgers
"[...] European worries slam stocks" -- MSN Money
With headlines like these, it's easy to get caught up in the frenzy of what's going on in Europe. But before you do, here's a little background. Causes of the crisis differ from country to country. Essentially, it is becoming increasingly difficult for countries such as Greece, Portugal, Spain, Cyprus and Italy to restructure their debt. These countries owe a lot in relation to what they are making, and asked countries who were more financially stable, like Germany, to back up their debts. The hope was that these countries could get better terms on their loans because the loans would be less risky with a second backer (like parents cosigning a mortgage). The terms are still being negotiated. Because no one knows how the debt crisis will play out, there is a risk that our economy will be affected. In the meantime, however, we may be affected by something called headline risk.
Headline Risk
News headlines are constantly filled with doom and gloom. News stories can have a negative impact on investments, even if they are unsubstantiated. This is known as headline risk.
The predictions in these headlines might be very real; however, we really can't predict the outcome of current negotiations. One common example of headline risk is when a company's shares drop due to negative media coverage of an executive scandal. These headlines and other media hype can encourage people to sell their investments and push prices down even further.
Facts
This sounds very grim indeed. We might assume that our economy will be adversely affected and that we shouldn't invest in international bonds. These are distinct possibilities, but let's look at some facts in order to make an informed decision.
1. Exports: The United States' total exports comprise 14 percent of GDP. Exports to the eurozone represent only 14 percent of this total.
2. Investments: At the end of 2011, 30 percent of worldwide mutual fund investments were based in Europe.
3. More than 50 percent of the sales of American-owned foreign affiliates are in Europe.
4. Germany is the sixth largest economy in the world with a budget deficit below 3 percent of its GDP. This is in comparison to the U.S. budget deficit at 12 percent of its GDP. The U.S. is the world's largest economy though the entire EU economy is larger as a group.
If you have a business catering to European tourists you may feel the burn. If you have all your money invested in European bonds, the crisis will have a negative impact on your net worth. The debt crisis will most likely have an impact on us, but how large will it be?
Opinion
The effect the European debt crisis will have is a matter of degrees and exposure. It's hard to discern how these unfortunate events will affect us and what actions we should take. In other words, what do we have control over and when are we just being reactive?
It is important to have a financial plan in place that you understand and have confidence in. That way you can stick to it, so it can meet your needs over time. We also want to differentiate between headline risk versus a real problem with the investment. The difficulty in this is that there is no way to predict how investments will perform in the future. Headline risk generally has short term effects causing prices to dip, but the effects do not persist in the long run.
Could you lose money if part of a mutual fund you own is invested in these assets? Of course, but that doesn't mean you necessarily want to make a rash or reactive decision.
It is critical to understand the extent of your exposure and the purpose of your investments. You should also make note of the reason you chose them and potential circumstances when you should make adjustments. This can all be documented in the form of an investment policy statement.
There are a lot of moving parts in our global economy that affect our investments. It's hard to know how to react and what the ramifications will be for events like the European debt crisis, as well as subsequent market fluctuations. However, if we put an investment plan in place, we are better prepared to SaveUp in the long run.
This post was written by SaveUp's personal finance contributing writer, Catherine Hawley, CFP®.