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So what if there's a default? 5 things to remember

Monday, 7 Oct 2013 | 1:28 PM ET
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Washington's government shutdown is threatening to morph into something far worse—a government debt default that some believe could plunge the nation into a crippling depression.

For ordinary Americans, the consequences likely would mean a bear market in stocks, a possible interruption of government payments such as Social Security and Medicare reimbursements, and substantial losses in bonds, where mom-and-pop investors have piled the vast majority of their cash over the past decade.

Of course, reality is likely to be something less extreme though still disruptive.

Financial pros say now's a good time to think about portfolio protection, risk—as well as the lessons we have and have not learned since the financial crisis devastation.

"People need on an individual basis to continuously reduce their personal levels of debt," said Julie Murphy Casserly, president of JMC Wealth Management in Chicago. "People today for the most part don't have adequate short-term buckets to move through stuff like the things going on in Washington,"

Casserly and other financial pros said investor action in the wake of a potential default should break down into five areas: 1) Holding adequate cash levels; 2) not panicking; 3) rebalancing; 4) taking a global investment perspective, and 5) buying downside portfolio protection.

Cashin: This will be 'like 'no other default' global finance has ever seen
Art Cashin, UBS discusses what is driving stocks and why there may be a "flight to safety" from equities to bonds, amid the lingering government shutdown.

(Read more: First a default, then a depression? Some think so)

Six months of cash not cutting it?

For generations, the baseline for financial advisors was that clients should hold four to six months of cash to brace against unforeseen crises.

Casserly said she thinks the new paradigm could be twice that—or more.

"Is six months enough? These cycles last much longer now. The average debt crisis takes a decade to clear out of the system. We had the worst ever, so it's going to take more than a decade," she said. "I'm really wanting people to have somewhere between like nine to 15 months."

In event of a default, the government could end up having to prioritize which bills it pays and programs it funds with whatever cash it has on hand. Transfer payments likely would have a high priority, but the uncertainty serves as a reminder of how important cash is in a post-crisis dysfunctional-Washington world.

"I'm still shocked at how numb people are to having high debt levels," Casserly said.

Keep calm and carry on

Well-known banking analyst Dick Bove at Rafferty Capital Markets expects a debt default to lead to a full-blown depression that could take decades to recover from, and it's a scenario that can't be dismissed.

However, few analysts or economists believe even the current batch of Washington warriors would allow a default to happen.

Making rash investing decisions based on scary headlines, then, could have severe consequences.

(Read more: Washington baits, Wall St. doesn't bite on panic)

"Investors should not panic and should stay the course, remaining focused on their strategic asset allocations," Ashvin Chhabra, chief investment officer at Merrill Lynch Wealth Management, said in a report for clients.

He added: "We urge investors to distinguish between political posturing that may lead to short-term market volatility and those decisions that may have implications for long-term returns."

Wall Street's dirty little secret: Where's the panic?
Jonathan Corpina, Meridian Equity Partners, weighs in on how the shutdown is impacting the markets.

A question of balance

Political turmoil in 2013 has included not only the government shutdown and debt ceiling battle but also a series of tax increases and spending cuts that Wall Street analysts and Federal Reserve Chairman Ben Bernanke expected to clobber the economy.

And while growth may be a shade under par, the stock market has roared, sending the S&P 500 stock market index up more than 18 percent.

The downside of such an aggressive move, though, is that individual portfolios can get out of whack.

A balanced portfolio should reflect investor risk appetite, with a healthy mix of not merely stocks and bonds but also the different categories within those broad investment classes—domestic vs. international, growth vs. value, high-yield bonds vs. investment grade, just to name a few.

The debt ceiling disturbance is a good opportunity to examine allocations.

"In preparation for what could potentially be a rocky month ahead, we believe investors should make sure they have adequate cash to withstand the potential upcoming volatility," Dean Junkans, chief investment officer, and Tracie McMillion, asset allocation strategist, at Wells Fargo told clients. "Investors may want to consider using (market rallies) to build cash positions if necessary and align asset classes to their target allocations."

Go global

As part of that rebalance process, investors may want to take a fresh look at international markets.

U.S.-centric stocks have been dominating the landscape for the past two years as Europe has meandered through its debt crisis and China's economy has slowed.

That trend has changed over the past quarter or so, with many foreign markets doing quite well. Investors can play global markets easily through exchange-traded funds that track market indexes.

(Read more: Debt ceiling flashback: The biggest decliners)

For instance, China, as measured through the iShares China Large-Cap ETF, is down about 7 percent for the year but up nearly 16 percent in the third quarter. An ETF representing the so-called BRIC countries of Brazil, Russia, India and China—the Guggenheim BRIC—is off 1.8 percent this year but up more than 15 percent in the third quarter.

"While September was a good month for US stocks, it was even better (for) international markets," Bespoke Investment Group said in an analysis.

Get protection

Those with a shorter-term time frame have a variety of means to insure against quick market downturns.

The CBOE Volatility Index, commonly known as the VIX, allows investors to buy options that pay off in the event the market declines. A basic put option on the S&P 500—the ability to sell the index at a designated price point—is also an easy way to get a better sleep in the event of a near-term market downturn.

Patience, though, can sometimes be the ultimate portfolio protection.

(Read more: Get out the rally hats: Shutdowns are bullish!)

Incorporating all the lessons above—accumulating cash, not panicking and looking for underbought areas of the market—all can pay off in times of turmoil.

Quincy Krosby, chief market strategist at Prudential Annuities, said the clear signal from the markets, whether it's stocks, bonds or the relatively meager cost of Treasury credit default swaps—which protect against a U.S. default—is that a default is not going to happen.

"It behooves investors to take precaution," Krosby said. "But the overriding thinking is they want to take advantage of a buying opportunity."

—By CNBC's Jeff Cox. Follow him on Twitter @JeffCoxCNBCcom.

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