A penny saved' and well-invested?

March 1, 2006

Stocks carry the most risk, but provide the best return over the long run; bonds are not as risky as stocks, but have a lower return; cash provides the most safety for your principal, but with earnings that may barely keep up with inflation.

Building your practice to the point where it generates a healthy bottom line is just the first step on your journey to financial security. How you manage your money after you earn it is an even more essential key to your financial future.

Whether your retirement is a long way off or just around the corner, inflation makes it critically important that every dollar in your investment portfolio and retirement accounts be kept working for you around the clock. Making that happen is not as easy as it used to be.

Chances are that you're familiar with the basic rule of thumb for personal investing: Stocks carry the most risk, but provide the best return over the long run; bonds are not as risky as stocks, but have a lower return; cash provides the most safety for your principal, but with earnings that may barely keep up with inflation.

Recent study

A recent study by the market data firm of Ibbotson Associates may help you to decide. The study provides average annual returns with compounding and reinvestment of dividends over the 80-year period from 1926 to 2005.

The highest return (12.6 percent) came from small-company stocks (typical of the smallest 20 percent traded on the New York Stock Exchange (NYSE)). The next-highest return (10.4 percent) came from large-company stocks. Long-term government bonds yielded 5.5 percent. Last place in the yield race was cash (3.7 percent), represented by the 30-day Treasury bill.

All of these figures are before inflation, which averaged 3 percent during the period. To get the "real" return, of course, we must subtract inflation's 3 percent from the above figures.

If we subtract inflation's 3 percent from cash's 3.7 percent return, we wind up with a real return of only 0.7 percent - terribly close to no return at all. At the other end of the scale, we have a real return of 9.6 percent from small-company stocks and 7.4 percent from large-company stocks. Bonds fell in the middle, with a real return of 2.5 percent.

From these figures, it's easy to see why financial advisers recommend substantial investments in stocks for any portfolio. For younger investors with a 30- or even 40-year window before retirement, some advisers might recommend allocating as much as 80 percent, or even more, in stock investments. Investors at the other end of the age scale, nearing retirement, may be advised to reverse that figure with 80 percent in bonds and cash and only 20 percent in equities.

In the real world

But how does all this work in the real world? What does all this mean to you and the decisions that you must make in the management of your investments? How much can you depend on the long-term averages to repeat during your investment window of time? That, of course, is where the rub comes in.

A look at the charts that map the ups and downs of the market over the years suggests that you have a good chance of matching the average figures over periods of 10 years or more. However, the results during shorter periods can differ drastically from the averages. Down periods in the market lasting two or three or more consecutive years are not uncommon - and who doesn't remember the roaring '90s, when double-digit returns could be found in almost every investment category?

It's that volatility in the market's behavior that suggests that younger investors can safely and profitably ride out market extremes, while older investors nearing retirement are advised to allocate their assets toward the more conservative and stable investments such as bonds.

Still, most experts suggest that even people in their 60s and 70s should keep some investments in stocks. With average life spans increasing to the point where 90-year-olds are no longer a rarity, keeping up with inflation is a necessity for just about everyone.

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