Investing involves risk, so why do we do it? Why not just put everything in FDIC insured bank accounts and go about our lives without having to worry about the volatile markets?
The reason: Inflation.
Inflation has averaged approximately 3% since 1926. That means something which cost $1 then, would now cost $13 (a 92% loss in purchasing power). Simply socking money away in bank accounts means that your savings are losing value.
If you want to maintain the purchasing power of the savings you already have, you'll need to invest. Historically, short-term bonds (represented by the green line on the chart) have kept pace with inflation, plus a small premium. However, after accounting for income taxes that would be due on the nominal return, you'd likely still have lost some purchasing power.
If your goal is to obtain real growth after inflation and taxes, you'll need to invest in riskier assets, such as longer-term bonds and stocks. Since 1926, long-term bonds (yellow line) have earned an annualized 5.7%, while stocks (blue line) have earned 9.8%.
After comparing the historical performance of bonds and stocks, you may be tempted to invest solely in stocks. After all, who would want a 3.5% or even 5.7% return, when a 9.8% return is available? Here's the caveat - risk and return are related. In order to get higher expected returns, you'll need to take more risk and be able to withstand the inevitable downturns in the market.
From November 2007 to February 2009 the stock market lost 51%. Even worse, from September 1929 to June 1932 during the Great Depression stocks lost 83%. In both cases, the market subsequently recovered and not only returned all the losses, but hit new highs. Even so, these massive drawdowns would scare even the most risk-tolerant investors, and selling at the bottom of a market cycle is a sure-fire way to permanently lose your savings - far worse than inflation and taxes.
For most investors, the answer is a balanced approach - a mix of cash, bonds, and stocks. Enough in stocks to reliably outpace inflation, enough bonds to dampen the volatility of the stocks, and enough cash to act as a reserve for unexpected needs and wants.
US Dollars. Monthly returns from January 1926 to December 2012. Stocks are represented by the S&P 500 Index. Long Bonds are represented by Long-Term Government Bonds. Short Bonds are represented by One-Month US Treasury Bills. Inflation is represented by the US Consumer Price Index (CPI-U). Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.