Financial planners suggest a few rules when it comes to investment strategies.
First, if you'll need to cash in your investments soon, then you should be holding liquid investments, such as certificates of deposit (CDs).
Second, if you have a longer time horizon -- meaning you won't need to access the money for a longer period of time -- you should consider some riskier investments, loading up on stocks and bonds. That time horizon may extend past your lifetime if your financial needs are otherwise secure, which means that more than likely, your nest egg can benefit your kids or even your grandkids.
A Primer On
If history is any guide, you can expect your investments to grow 4%, 6% or even 8% annually. A 6% gain on a $50,000 portfolio may not seem like much, but 6% year after year on an ever-rising base of assets starts to really sizzle. That's compounding. You may tend to think of it more when it comes to savings accounts or other interest-bearing itmes, but it also works with investments.
Let's take a look at an example.
Suppose you set aside $6,000 this year (I'm assuming you're 40 years old in this example). In addition to the 6% gain on the first year's investment, let's suppose you put in another $6,000 in the second year. Keep it up for five years and you've bagged $3,800 in gains in addition to the $30,000 you've put in.
Now let's say you keep it up for another 10 years, picking up 6% annual gains on the nest egg along with another $6,000 in freshly injected funds each year. Now compounding is really starting to pick up. You've put in $90,000 ($6,000 a year times 15 years), but also have a nearly $50,000 gain to show for your efforts.
The next 10 years, your results are better still. You've now put in $150,000 ($6,000 a year times 25 years), but made even more than that in profits. When you're looking at 6% gains on $300,000, you're talking about stellar gains.
And if you stick with it for 10 more years, you'll now be sitting on a really impressive pile of cash.
By the time you hit 74, you'll be bagging nearly $40,000 in annual gains -- far higher than the $6,000 you've been injecting each year.
Of course, sitting on a $669,000 nest egg may not mean as much after you account for the corrosive effects of inflation. But it's important to remember that stocks and bonds tend to appreciate faster than inflation over an extended period. At times of high inflation, as was the case in the 1970s, investors prefer the high payouts of bonds. In times of low inflation, stocks tend to hold relatively greater appeal.
That means you can't simply put money into one asset and ignore it. You need to rotate to wherever the best returns are likely to be. In fact, Robert Arnott, chairman of money manager Research Affiliates, found that stocks outpaced bonds by 2.5 percentage points annually during the past 210 years (though he cautions that bonds have outperformed stocks in certain periods, such as the most recent decade).
The Investing Answer: A balanced approach of stocks, bonds, real estate and commodities funds may be your best shot at capturing that 6% return. Stocks can do better than that for an extended period, but they can also hit major speed bumps (in fact, they did twice in the last 11 years).
The power of compounding only works if you have a long-term time horizon. Gains after the first few years are likely to be unimpressive. But a few decades later, compounding will have yielded powerful gains for a portfolio.