Understanding the 2 hidden risks in long-term investing

The uncertainty we have seen in the markets in the last few years has caused many people to decide the risk is too great and has lead them to move their investments to very “safe” investments like CD’s, savings bonds, money market accounts or savings accounts. But there is another risk here that they haven’t considered.

Inflation

Historically, inflation has averaged around 3-4%. We are all well acquainted with inflation. Just make a trip to the grocery store or the pumps at the gas station. Doesn’t take long to realize that twenty dollar bill in my wallet won’t buy as much as it did last year or 5 years ago or 20 years ago.

This is an important factor to remember when considering your long-term investments. If your investments don’t earn more than the the rate of inflation that means your money won’t buy as much today as it would the day you invested it. The net effect in real purchasing power is you have lost money.

Taxes

Additionally, at some point you will have to pay taxes on your interest or on the gain you have achieved on your investments. In general this is likely to cost you another 2% of your earnings. So on top of the bite that inflation takes you’ll need to also earn enough to cover the taxes you will pay.

Getting tackled from behind

When looking at the long-term if you aren’t making at least 5-6% on your investments you are really losing money. In essense you are getting chased down and tackled from behind by inflation and taxes.

Warren Buffet discussed this in his most recent  Berkshire Hathaway letter to shareholders. He noted that every $1 that he invested in 1965 needs to be worth at least $7 today just to have the same buying power it did the day he invested it.

This is the risk that people don’t consider when they look for “safe” investments. To me safe means that at least my money is protected. I am not losing purchasing capability. But when I put my money in very conservative investments like CD’s or Savings Bonds where at best I may be making 2% or 3%, the truth is I’m really losing money.

So what is the answer

First of all, in this discussion we are talking only about long-term investments. Short-term savings accouts or your emergency fund are not investments. This should be treated differently. A savings account or better yet a money market account is approriate for these.

But for true investments where you do not plan to touch the money for more than 5 years, you have to take enough risk to beat inflation and taxes. The best way to accomplish this is through investing in mutual funds with long track records of success. This will provide enough risk to make sure that over the long haul you out earn inflation and taxes, but will keep you well enough diversified that you should be able to weather the ups and downs that come from normal ebbs and flows of the stock market.

Has your view on investing changed since the market drops of 2008?

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