NEW YORK (MONEY Magazine) -
Bright as the future may look, all forecasts are just educated guesses, and I'm certainly not advocating that you ignore the risks.
The worst-case scenario du jour is a collapse in the value of the dollar. But there are other possible causes of concern that could stall the market's recovery.
For starters, Federal Reserve chairman Alan Greenspan could raise interest rates too much. He has already hiked short-term rates four times in six months. However, if inflation remains low, a further rise in interest rates could be too much for the economy to absorb. The good news is that Greenspan generally avoids such mistakes.
Another concern is that consumers, who account for two-thirds of the total economy, might put away their wallets. Many Americans are carrying too much credit-card debt, and any upturn in mortgage rates could erode property values and make homeowners feel less affluent.
Here again, though, the odds favor a happier outcome, in my opinion. At current interest rates most consumers don't have a problem carrying their debt. And the risk to home prices seems overstated (for more on real estate, see "Last hurrah?").
The final major risk is a big spike in the price of oil. That's conceivable if terrorists start hitting oil production and refining facilities. But as I said earlier, the more likely scenario is that prices fall as supplies increase. There are also smaller possible surprises that might hurt particular market sectors. Here are three examples.
Productivity gains could diminish. No one really understands why increases in productivity have been so strong over the past decade. Some people say the personal computer has transformed the service sector. Other say Americans are simply working harder. Whatever the explanation, high productivity helped maintain growth with low inflation during the 1990s. If that stops, growth may be weaker and inflation may be higher; service companies would suffer most.
The budget deficit could fire up inflation. To date, the deficit hasn't had much of a negative effect on growth or consumer prices. But the 1.7 percent gain in the producer price index for October is more than double the rate for recent months. That pushes wholesale inflation over 12 months to 4.4 percent. If that rate continues, companies that can't pass price increases on to customers stand to get hurt.
More industries could be the target of investigations. The drug and insurance industries have been rocked recently by civil lawsuits and possible criminal charges. It may appear that the worst offenders have already been exposed, if not always punished. But other firms could be targeted, and existing disputes may get more serious.
There are dozens more scenarios, but there's no point in trying to sidestep these risks completely. Yes, you could keep your money in totally safe investments, but the returns would be so low that you'd fall short of your long-term goals.
The best you can do -- in 2005 or any other year -- is make prudent choices about the likeliest future outcomes and always hedge against the possibility you could be wrong. That's why proper diversification is so important. Get that right, and you'll be braced for most of the surprises that come your way.
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