Cash investments are an effective way of managing your money to meet short-term goals and to provide a safety net for emergency expenses. Because cash investments are considered low risk, they generally pay modest interest rates — usually not enough to offset the combined effects of inflation and taxes on your investment.
For example, if you put $10,000 in a money market account earning 4% interest, you'd accumulate $20,300 after 18 years. If inflation averaged 4% per year, your account would actually be worth $10,150. After taxes, you'd have considerably less buying power than when you started.
But if you'd invested the money in a portfolio of stocks earning an average of 8% for 18 years, you'd have $40,000. After accounting for inflation, you'd still have $20,000, or twice what you started with. Plus you'd pay taxes on your earnings at the lower long-term capital gains rate.
Preserving your principal
If you're so worried about the possibility of losing money that you put your money only into cash equivalents, you're investing to preserve your
principal.
Basically that means you get back what you put in, plus whatever modest amount of interest you earn.
While preservation of principal is an appropriate short-term strategy, as a long-term investment strategy it has serious risks. The double blow of taxes and inflation steadily erodes your
real return,
or the purchasing power of what you get back in relation to what you invest.
Inflation
The rate of inflation varies from year to year and rises and falls depending on several factors, including the economy and the strength of the U.S. currency overseas. Since 1926, the inflation rate has averaged 3% annually. That includes the high point in 1980, when it hit 14%, and several years when it hovered around 1%.
