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Regular investments are an easy way to save

12/13/2004

During the 1990s, the magic road to riches meant buying the right tech stock and watching your investment soar in value. Those days are gone, and with them our dreams of fast and easy money.

Now we are back to making money the old-fashioned way: saving and investing "for the long term." I do not always agree with the "buy and hold" philosophy, but I do agree it's possible to get rich slowly through "compounding" -- increasing the value of your investments over time. Compounding includes the reinvestment of income from your investment as well as the increase in the market value of your stock, bond or mutual fund.

Gains in the value of your investments come from two sources:

1. Income from your investment in the form of interest (from bond investments) and dividends (from stock investments). Many -- but not all -- stocks pay dividends, and some increase their dividend payments each year.

2. Capital appreciation, the increase in the value of your investment. However, appreciation is not a given, as the past four years have shown.

So the total return on your investment includes the income and capital appreciation over time.

To compound your investments you need to do the following:

1. Make investments each year -- systematic monthly investments are best. You can compound a single investment, but multiple investments are better.

2. Select sound stock investments that have a history of paying dividends and increasing their profits each year; or, if you are buying mutual funds, be sure the fund has a good and consistent long-term track record. The biggest gainer in one year is often the biggest loser in the next year.

3. Check your investments periodically, and get rid of losers sooner rather than later.

4. Reinvest all income and capital gains. This is crucial to compounding.

5. Start early -- the more time you have to compound your investments, the more you will have when you retire.

6. The early years are the most important. If you wait to invest, you may have to invest a lot more and for a longer period of time to reach your goal.

Bonds (debt investments) do not usually increase much in value, but they do have guaranteed interest payments. Stocks and mutual funds that hold stocks in the portfolio may pay dividends that can be reinvested.

So when you reinvest your income, you are compounding your return on that investment. The most valuable part of compounding is time. The more time you have to compound your investment, the greater the increase. For example, the Investment growth table shows the increase of an investment in five 10-year periods. The investment is assumed to grow at 7.2 percent per year.

An easy way to calculate the growth of an investment over time with different rates of return is called the rule of 72. It works like this:

1. Estimate how fast your investment will grow each year -- 10 percent per year, for example.

2. Divide this number into 72 -- 72/10 = 7.2

3. This will give you the number of years for your investment to double in value. For example, in 7.2 years your investment will double at a 10 percent rate of increase. At 12 percent per year, your investment will double in six years, and at 5 percent your investment will double in 14.4 years.

We have looked at the growth of a $1,000 investment over 50 years. The investment value table assumes you invest $1,000 per year in a retirement plan with a 7.2 percent rate of return over a 50-year period. Investing small amounts each year for long periods of time can create a substantial amount of retirement capital, and if you invest in a Roth IRA, all of the withdrawals will be tax-free.

In my last article, I wrote that an E-7 retiring after 20 years would need to have at least $500,000 to $668,000 in retirement funds to duplicate his pension. If your rate of return on your investments is 7.2 percent, it would take an investment of $12,000 per year to equal approximately $500,000 after 20 years.

It is important to remember that investment returns are not equal each year, and in fact may be negative in any particular time period. Your own investment returns will be higher or lower than the illustration and will not be the same each year. Equal annual returns were used only to illustrate the effect of compounding.

There is an excellent article on compounding at www.dowtheoryletters.com, which you can read for free.

Bottom Line: The earlier you start to invest, the more money you will have. If you can let your investments grow for a longer period of time, the amount of increase in your investments is much larger. The biggest increase in value is in the last 10 years. In a future column, I will discuss low-risk ways to grow your investments.

Note: To clarify a point from my Aug. 9 column regarding Roth IRAs:

1. Regular IRA conversions to Roth IRA's are always taxable, there is no exclusion for conversions during deployment in a combat zone.

2. If you have nondeployed salary income or other taxable income, the Roth conversion amount may result in taxable income on your return if not offset by your deductions.

3. Please consult with your tax adviser before doing the conversions, additional taxes may be due. If a mistake is made, the conversion may be reversed before filing your return in 2005.

Barbara Pietrowski is a licensed certified public accountant, certified financial planner and personal financial specialist. Her practice includes tax preparation, fee-only financial planning and investment management, and her office is in Kensington, Md. E-mail her at barbarapietrowski@yahoo.com.