What Investors Should Do If We Go Over the 'Cliff'

Investors banking on some resolution to the fiscal negotiations in Washington may want to consider what will happen if they're wrong.

After all, negotiations over the "fiscal cliff" aren't going particularly well, and there even are increasing calls that entering 2013 without an agreement might not be so bad. (Read More:Fiscal Cliff Worries Just Noise: Kass)

Cliff Scene: Butch Cassidy & The Sundance Kid
20th Century Fox
Cliff Scene: Butch Cassidy & The Sundance Kid

In such an uncertain environment, preparing for an extreme scenario is important.

"You always have to have a plan B. There's no question that investors should be prepared for changes that could be coming next year," said Tim Steffen, director of financial planning at Robert W. Baird. "Until it's fixed it's not fixed." (Read More: The Most Dangerous Idea in Washington: Economist)

There remains a reasonable chance that Congress and President Barack Obama will reach some meeting of the minds this month over the cliff and its associated tax increases and spending cuts, and an even better chance that even failing a 2012 agreement something would come early next year.

In the interim, though, the impasse could cause lots of damage.

One scenario considered likely in that case is a market sell-off on par with what happened in September 2008 when Congress initially failed to reach an agreement on bailing out Wall Street banks hammered during the subprime mortgage collapse. Stocks crumbled 30 percent in two weeks, with the reaction on Wall Street ultimately pushing Washington into making a deal.

A similar situation may have to happen to get a cliff deal.

"The reaction was dramatic. That caught the attention of Main Street," said Quincy Krosby, chief market strategist at Prudential Annuities. "If you believe nothing is going to be done, if you believe the two sides cannot agree on anything - even to disagree - then maybe that's what's necessary." (Read More: Going Off 'Cliff' Would Help Wall Street: Gov. Dean)

Of course, a market meltdown likely would mean, as it did in 2008, an opportunity for investors willing to ride out the mayhem.

"If we get a sell-off we come back to the way we look at the world, which is what companies out there are still able to grow, that are maybe less impacted but get sold off with everything else," said Brian Lazorishak, senior portfolio manager at Chase Investment Counsel. "What we're attempting to do...is to keep a shopping list of stocks."

That means scooping up "higher-quality names with good growth outlook and accumulating some of those in a market weakness."

Indeed, a focus towards quality likely would be critical in that higher taxes on dividend and income—virtually assured with or without a deal—would constrain companies without access to capital.

"You're not going to be as heavily invested in equities, especially small- and mid-caps," Krosby said. "You're going to depend on growth, you're going to have a more defensive strategy in your portfolio."

Without a cliff deal, dividend taxes would rise to more than 43 percent.

Unless that scenario changes considerably, investors needing to raise cash for personal expenses, such as college tuition or a new car purchase, should sell dividend-paying stocks before 2012 ends, Steffen said.

"The thing to keep in mind is they should all be investment decisions first, and not tax decisions," he said. "If you have a strong investment that can outperform a tax increase, then there shouldn't be any urgency to sell to lock in today's rates."

Some of those considerations, though, could be different for fixed-income investors.

Municipal bonds in particular have been popular and leading performers this year because of their income-generating ability and tax-exempt status. However, stripping munis of their tax treatment is on the table and could be a significant casualty of a cliff agreement. (Read More: Even Muni Bonds May Be Targeted in 'Fiscal Cliff' Talks)

One proposal considered most likely would tax munis at a 28 percent cap for top earners. That means muni holders would pay their normal income tax rate minus 28 percent on their holdings.

"The cost of such a provision to issuers and investors would be substantial, in our view," said George Friedlander, fixed income analyst at Citigroup. "It would, if enacted, severely damage the value of existing municipal bonds, and push the borrowing cost for new bonds substantially higher."

More broadly speaking, investors with sanguine views about the outcome of the cliff negotiations could find their mettle tested.

"You don't want the market to determine how we fix the deficit. If the market decides how we're going to do it, it's not going to be pleasant for equities or fixed income," Krosby said. "We need to do something now for the future."