Blogs | February 16, 2015

We are living in a time of great uncertainty. Here’s what to do about it

When the only constant is change, what can the average person do to reduce financial risk?

Sometimes, the cliché is right. We really are living in a time of great uncertainty. Will robots take our jobs, as MIT’s Erik Brynjolfsson argues, or is technical change actually slowing as Northwestern University’s Robert Gordon says? Are we in an era of secular stagnation, as Harvard’s Larry Summers says, or will this prove to be only temporary?

Uncertainty in jobs
But it’s not just macroeconomic uncertainty we face. There are no jobs for life any more. Young people starting work now expect to have 15-20 jobs in their lifetime. That’s quite reasonable, given that creative destruction means that there’s a big chance that even huge household name companies might not survive a 40-year working lifetime.

Shifting risks
Worse still, many risks have been shifted from society or groups onto individuals, and particularly onto younger people. The closure of final salary pension schemes in favour of defined contribution ones has shifted investment risk from firms to workers.

High house prices mean that the only way to own a home, for many people, is to take on massive debt. And there’s the risk that we might have to find tens of thousands of pounds late in life to pay for care in our old age.

All this poses the question: what can we do to manage these risks? There’s a lot that politicians could do to spread risks better, and – as Yale University’s Robert Shiller has shown – there should, in theory, be financial products which allow us to insure against such risks.

We will, however, grow old and die waiting for politicians or the financial services industry to do the right things. So we’ve got to cope ourselves. Luckily, there’s quite a bit we can do.

Be flexible enough to cope with change
There’s one key principle here: ensure that you have flexibility to cope with shocks and change. For those of you young enough to choose a career, this means making sure you acquire general purpose skills – ones which can be transferred across jobs and industries: traditionally, these have included law, accountancy or teaching.

It also means – if you can – start making good money as soon as you can while learning transferable skills to give you more flexibility later in life to move into lower-paid but more fulfilling work.

Dillow’s five keys to managing long-term financial risk
Many of us, however, are past the age when we can make such choices. But there’s a lot we can do to manage long-term risks. Here are five possibilities:

1. Save – and start doing so as soon as you can. We can’t predict long-term returns on financial assets. But we do know that compounding is a powerful force. For example, if you save £1000 a year for 25 years with a real return of three per cent (a reasonable assumption for a basket of cash and equities) you’ll end up with £36,459. But if you save for 30 years, you’ll have £47,575. This means an investment of an extra £5,000 will earn you over £11,000. That’s a return of over 100%.

2. Hold some cash. Yes, real interest rates are negative, which makes it tempting to either spend or invest in riskier assets – which is precisely what central bankers want us to do. But cash has the huge advantage of being easily available in an emergency, such as if you lose your job. If you have to sell shares to raise cash, you might have to do so when prices are temporarily low.

3. Don’t try to be too clever. The world is unpredictable, so it’s impossible to get everything right. The solution to this is not to try. Simply find an asset allocation that you are comfortable with and stick with it. Personally, my financial wealth is divided roughly evenly between cash and equities – and I rarely change this composition.

4. Invest in equities through tracker funds. These have two big virtues. One is that they have low fees; this matters, because charges compound horribly over time. The other is that they back the field rather than particular horses. Betting on individual companies over the long run is silly because, in the long-term, earnings growth is unpredictable and the risk of corporate death is high.

5. Avoid the obvious mistakes. These include: trading too much and so incurring dealing fees; buying expensive actively-managed funds which don’t out-perform the market; holding onto losing stocks in the hope they’ll come good; and being swayed by peer pressure into buying over-priced shares.

In a complex and unpredictable world, some mistakes are inevitable. Let’s at least cut out the ones we do know about.

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Chris Dillow
Chris Dillow

Investors Chronicle writer and economist