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Why You Need to Be Invested in the Stock Market

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  • Why You Need to Be Invested in the Stock Market

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    Time and the Power of Compound Interest

    The longer you have your money invested in stocks or real estate, the more time you allow you money to grow. You also allow yourself time to make up for periods in the market when there is an extended period of time when the market suffers through a correction (like now) or is flat. At its low, the stock market has retracted more than 50% from the high. Depending on your portfolio, you may have experienced a larger downturn. This has been a decade of returns close of 0% for the S and P 500. In 2000, the Nasdaq reached a high of 5000. Today, it is well less than half of that. The Nasdaq may not rise to 5000 for another 10 to 20 years. No doubt we've lived through an extraordinary period in financial history. Those that have a decade or more to invest now have the opportunity to purchase stocks and homes at a discount compared to a few years ago. The housing and stock market may again see another significant downturn. However, the fact remains that if you make some intelligent investment decisions now, you have the opportunity to see some very good returns in the decades to come.

    If you have 10, 20, or 30 years to retire, I have some good news and bad news. The good news is you have compound interest and time on your side. In the investment world, there is a common principle known as the rule of 72. The rule of 72 states that if you divide your expected return by 72 and you're money will double in value. For example, if you invested $100,000 today and received an expected 8% return, your money would double to $200,000 in 9 years. Given another 9 years and that $200,000 will again double to $400,000.This is the power of compound interest. It is the major reason why you need to start investing money now. And now the bad news.....

    Retirement enemies
    To make sure all of your investable money is included in the equation, you must take into account commissions and taxes. If you invest in mutual funds, you will most likely have to endure capital gains. If your mutual fund has bought and then sold a stock during the year, the fund must pay capital gains on the sale. The capital gain is your burden to bear even if you have not sold any of your shares during the year. This is why those savvy investors choose tax-efficient low turnover mutual funds. The lower the turnover, the lower the taxes you'll pay. You need to keep as much of your money invested and out of the government's hands as possible.

    In addition to taxes and commissions, you have another big enemy; inflation. Inflation has been running at a historical average rate of about 3% according to Ibbotson Associates. Inflation will put a huge financial burden on your retirement plan. If your return on your investment is 9% and taxes reduces it another 2%, your real return is 7%. Factor a historical rate of inflation of 3% and you're left with a net return of just 4%. If you start with $100,000, your money's purchasing power will be reduced to $73,700 in 10 years, $54,000 in 20 years and to just $40,100 in 30 years. Most asset classes over the long run don't even come close to returning 9%. In a study by the Vanguard group, an all bond portfolio returned 7.9% between 1960 and 2003. A balanced portfolio of 50% stocks and 50% bonds returned 9.2%. Invest in a 100% stock portfolio and your return would have been 10.5%. If you have a long time horizon over 10 years, this is precisely why you need to be invested in stocks.

    Note: Given the last 10 years, that total return number has been skewed downwards to around 9%. However, even with the recent declines, there is a strong case for stocks. Invest in "safe" bonds or pay attention to the advertisements by your bank offering to safely returning you 2% and you will definitely end up short of your retirement goals.

    Stocks have overcome roadblocks in the past
    If you look back to history you will see the equity market has endured many traumatic events. There was of course the Great Depression from 1929-1937. In the 70's there was runaway inflation. Recently we've seen the dot com bubble, the Dow crash from 14,000 to 6500 and the real estate market collapses all in the same decade. Don't forget 911. Somehow, the equity market has revised to its mean return of roughly 10%. If past history is a precursor to the future, investors will suffer through many events in the coming decades.

    The key to investing is to know that these dramatic events are coming. How you react to these events is the key to a successful investment career.

    The article above is intended to provide information of a general nature and may not be suitable for your individual situation. Please consult a qualified licensed financial advisor before making any financial decision.

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