Keep calm when the market panics

Most of us know that Greece is bust. Politicians and central bankers staying up all night isn't going to change things. It's now become a damage limitation exercise. There is no easy way out.

On Monday, it seemed that the markets were on the verge of panicking as shares in London fell heavily. Investors are so bearish that they are prepared to lend money to the German government for two years for virtually nothing: 30 year bunds yield less than 2%. Capital preservation is the order of the day.

What should investors do? We're not going to pretend that the economic outlook is rosy, but let's get a few things into perspective.

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Take the UK stock market: the FTSE 100 fell by over 2% yesterday and is nearly 15% lower than the highs of last summer. That's not good, but it's important to remember that the FTSE 100 is a very unbalanced basket of stocks.

Over one third of the index is made up of oil & gas, banks and mining shares. It's therefore not surprising that when the world worries about economic growth and the solvency of banks, the FTSE 100 falls heavily. If ever there was an argument for not owning a FTSE 100 tracker fund, this is it. Owning a diverse portfolio of solid companies is a better way to go if you want to own shares.

What's clear, though, is that you should stay clear of bank shares: European banks still have too little capital to protect them against big financial shocks. No outside investor really knows what's on their balance sheets, but the chances are they contain stuff that could go down in value a lot.

It would seem that some people in Greece and Spain are quickly working out that most of their banks are technically insolvent, and some are withdrawing deposits. A run on the wider banking system is probably what the EU leaders in Brussels are most worried about, and the rush to lend money to the German government for nothing suggests that a lot of investors are worried about it too.

Remember that in the UK, the Financial Services Compensation Scheme (FSCS) insures each deposit account that you have up to a maximum of £85,000. There is no need to panic, but you might want to spread your money around so that you get the maximum protection.

If we do enter a period of financial turmoil, then most assets will fall in value, as a meltdown of the wider banking system unleashes a deflationary credit crunch. That said, falling prices would mean that the purchasing power of cash increases, so holding a reasonable proportion of your portfolio in cash

seems to be a good idea, despite very low interest rates.

Other things you might want to consider are the corporate bonds of companies with very strong finances. Another option could be selected preference shares. For example, Royal Sun Alliance preference shares (LSE:RSAB) yield over 7% with dividend cover of nearly 40 times. This looks a fairly safe income play.

The other important point to note is that periods of market mayhem often provide excellent long-term investment opportunities. The stocks of very good companies can fall to levels that seem to good to be true. That's why it's always good to build a watch list of good companies so that you can move quickly when prices fall. In last week's MoneyWeek magazine, I identified a list of six excellent British companies that could go on your watch list.

And what about gold? My personal view is that the price of gold could go a lot lower from here. If an economic storm comes, then gold will be seen as an easy source of liquidity. Lower rates of inflation, or even deflation, would also see gold lose its short-term investment appeal.

But I would not sell gold now. Holding up to 10% of your portfolio in gold remains a sensible strategy. Why? Because sadly, the economic mess most of the Western world finds itself in has few remedies. I still fear that the problems of unsustainable government debts and fragile bank balance sheets will be fought with the printing press. The amount of money that would need to be created is colossal. What this does to the value of money will be of secondary importance to politicians and bankers, but if this comes to pass, you'll be glad you owned some insurance in gold.

Disclosure I own Royal Sun Alliance preference shares.