Your Money_ The Missing Manual - J. D. Roth [125]
Lurking behind all your plans for the future is inflation, your silent enemy. Inflation refers to the rising price of things; it's the reason a movie ticket that cost 10 cents in your grandpa's day now costs $10. Just as compounding in your bank account can help your savings grow bigger and bigger, the compounding effects of inflation constantly nibble at your wealth, making it worth less and less.
From December 1984 to November 2009, inflation averaged 2.96% per year. That probably sounds like just another boring statistic, but it's a number that has a real impact on your life. Because of compounding (which is working against you in this case), $100 from 1984 is worth only $48.68 today; in other words, you'd need $205.44 now to buy what $100 could get you 25 years ago.
As a rule of thumb, inflation is roughly equal to what you can earn in a high-interest savings account. So even though your money grows thanks to compounding, it's almost like you're swimming against the tide: You paddle forward as fast as you can, but inflation keeps dragging you back so you just stay in the same spot.
Savings accounts are great for short-term goals; inflation may do a little damage, but it doesn't have time to compound. If you want to achieve your big goals over the long term, you need to do more than just boost your cash flow and stick money in savings. The best way to do this is to invest in the stock market because, over the long-term, stocks offer the best possible return. (When talking about investments, your return is the amount you earn or lose.)
How Much Do Stocks Actually Earn?
In his book Stocks for the Long Run (McGraw-Hill, 2008), Jeremy Siegel analyzes the historical performance of several types of investments (economists call them asset classes). He tries to answer the question "How much does the stock market actually return?" After crunching lots of numbers, Siegel found that since 1926:
Stocks have returned an average of about 10% per year. Over the past 80 years, stocks have produced a real return (meaning an inflation-adjusted return) of 6.8%, which also happens to be their average rate of return for the past 200 years.
Bonds have returned about 5%. Adjusted for inflation, their real return has been about 2.4%.
Note
You'll learn about stocks and bonds starting on The Tools of Investing.
Gold has a real return of about 1%. "In the long run, gold offers investors protection against inflation," writes Siegel, "but little else."
Note
Siegel doesn't mention it but, according to my calculations, real estate has also returned about 1% per year since 1926.
Siegel goes back even further than 1926, showing that if you'd invested just one dollar in stocks in 1802, it would have been worth more than $750,000 in 2006. If you'd put that dollar in bonds instead, it would have grown to just $1,083. And if you'd put it in gold, it would be worth $1.95. (All those figures take inflation into account.)
"The dominance of stocks over fixed-income securities [like bonds] is overwhelming for investors with long horizons," Siegel writes. In plain English: Over the past 200 years, stocks have outperformed every other kind of investment. But before you rush out and sink your savings in the stock market, you need to understand a few important points.
Note
Quick reminder: A bull market is a period of generally rising stock prices, and a bear market is a period of generally falling prices.
Average is not normal
Stocks offer handsome returns because they involve a lot of risk, meaning their value can fluctuate a lot (that's why they're described as volatile). The most important thing to know about stocks is that their average performance is not normal.
While it's true that stocks returned an average of about 10% annually (which works out to about 7% after inflation) over the past 80 years, in only two of those