IF YOU’RE INVESTING for the long haul, the biggest risk isn’t short-term market declines—unless you panic and sell during those declines. Instead, the big risk is failing to beat back the twin threats of inflation and taxes.
Suppose that, after investment costs, you earn 4% a year. If you lose 25% of that gain to taxes, you’ll be left with 3%. But if annual inflation is also 3%, you are—in financial terms—just running in place. How can you earn returns that outpace taxes and inflation? Smart tax management, especially the use of retirement accounts, can greatly reduce the threat from taxes. We tackle that topic in the chapter on taxes.
Even with smart tax management, you’ll find it tough to fend off inflation with Treasury bills, money-market funds, savings accounts and other cash investments. With these, the best you can hope for are returns that approach the inflation rate—and you may earn substantially less, as investors have in recent years.
Instead, to outpace inflation, you’ll need to look to bonds and especially stocks. With bonds, you might earn 0 to 2 percentage points a year more than inflation, depending on how much risk you take. The potential return from stocks is greater, though so too is the risk. Over the long run, U.S. stocks have delivered close to 7 percentage points a year more than inflation. But given today’s rich valuations and relatively sluggish economic growth, you probably shouldn’t expect long-run returns on a globally diversified portfolio that are more than 4 percentage points a year above inflation.
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