In a blog post from earlier in the summer, the Progressive Policy Institute’s chief economic strategist Michael Mandel smartly illustrated the unpredictable impact of technological innovation. Mandel observed that the two most important innovations of the past decade — gauged by their effect on the economy — are the smartphone and fracking. The smartphone changed the way we communicate. Hydraulic fracturing transformed the geopolitics of energy.
“Yet a decade ago, in 2006, the major business press wrote precisely two (2) stories about fracking — one in the New York Times, and one in the Wall Street Journal,” writes Mandel. “And while in 2006 journalists and analysts were writing about the possibility of an Apple phone, it was more with an air of bemused skepticism.”
The reason for highlighting Mandel’s observation is that the same insight holds with investing, especially for anyone with a 401(k) or similar long-term savings plan. For example, a decade ago a reasonable forecast was that emerging market equities offered the best combination of risk and reward over the coming decade. Yet from 2006 until now, the S&P 500 equity index sported an average annual return of 9.1 percent, compared with 1.6 percent for emerging markets. What do you think will happen over the next decade?
The uncertainty has important implications for how we manage our money. You can’t get rid of uncertainty. You can hike the odds of doing well with your money following four basic risk management techniques: diversification, rebalancing, dollar-cost averaging and low fees.
Since we don’t know which assets will zig and which assets will zag, diversification is a hedge against an uncertain future. It doesn’t always help out during a severe financial crisis, but the strategy pays off over a longer time frame.
Rebalancing is a discipline that keeps you at your planned asset allocation until you decide to make an adjustment to it.
Dollar-cost averaging means following a regular, automatic investment schedule (such as with a 401(k). The big advantage of dollar-cost averaging is psychological. The technique takes emotion out of the investing equation.
Low fees are critical to long-term performance; a percentage point can shave thousands off your retirement nest egg.
These techniques won’t help you make a killing in the markets. But they will help you sensibly manage your nest egg through the busts and booms in the markets and economy.
Chris Farrell is senior economics contributor, “Marketplace,” commentator, Minnesota Public Radio.