• Investment
• The Battle Against Inflation
• Total Returns Of Various Asset Classes
• The Power of Compounding

INVESTMENT

Introduction: People choose to spend their money in many ways. The bulk of most people's income goes for day-to-day living expenses: food, shelter, and clothing. But even if you live a no-frills lifestyle, it is important to make some investments for the future. A relatively small sum set aside each year can make an important contribution to your long-term financial security.

Investing often involves deferring or giving up current consumption. This is done to increase wealth and build future purchasing power. For example, to buy 100 shares of a stock, a vacation might be postponed. If the investment is successful, however, the profits from it could fund future vacations or a year of a child's college education. Specific investment decisions should be based on a consideration of risk versus reward. Some investments are riskier than others, and investors' tolerance for risk varies. In general, greater risk to the investor should be offset by probability or potential for a greater reward or a greater return on investment. The return is simply the profit earned on the investment, including capital gains and any interest or dividend payments. Returns are typically reported in pretax dollars.

This publication is a guide to investing, with an emphasis on understanding stocks, bonds, and mutual funds. A qualified investment professional can help you establish a portfolio tailored to your situation, but the more knowledgeable you are about investing, the more likely you are to be successful at it.

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The Battle Against Inflation

Investments can provide a way to keep up with or stay ahead of inflation. While inflation rates have fallen sharply from the peak levels of 1979-80, the dollar is still shrinking in value. A dollar squirreled away in a safe-deposit box in 1980 had only about 60 cents of buying power in 1993. Although every investment carries some risk, it may be even more hazardous not to invest.

An investment's so-called real rate of return is measured in terms of purchasing power, which is the nominal rate of profit growth adjusted downward for inflation. Among the kinds of investments shown in Table 1, common stocks historically have provided the best gains in purchasing power over the long term, followed by corporate bonds. U.S. Treasury bills, considered the safest investment of the three listed, recorded a compound annual rate of return of 3.1% over the period from 1926 to 1993, barely outpacing inflation.

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Getting started with investing as early as possible can make a big difference in how much wealth is ultimately accumulated. The benefits of saving early in life are greatly magnified by compounding. In this process, the growth of an investment's value is computed on the sum of the original investment, including the assumption that dividends or interest are reinvested in the same asset. For example, consider two individuals who can both receive a 10% compound annual return on their investment over a 40-year period. Let's suppose the first person puts in $2,000 a year for the first eight years, representing a total investment of $16,000, and then stops. At the end of 40 years, earnings from the original investment will have ballooned to $515,188 because of compounding. Meanwhile, let's suppose the second individual invests nothing for the first 8 years, then $2,000 annually for 32 years (Years 9 through 40), representing a total investment of $64,000. At the end of 40 years, despite having put in four times as much capital, the second individual's earnings will amount to $378,496, less than 75% of that of the first individual, who started earlier (see Table 2).

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