The other obstacle to financial security is harder to notice (because you never actually write a check for it, like you do to the IRS), but it's just as damaging as taxes. Inflation has averaged 3.2 percent from 1926 through 2008, according to the U.S. Bureau of Labor Statistics. Sometimes it's higher, like from 1973 to 1974, when inflation averaged 8.6 percent. Other times it's quite low, as in 1998, when it was only 1.6 percent. But over long periods, it has been remarkably consistent at 3.2 percent.
The sad truth is that taxes and inflation most hurt the people who know the least about investing. Let's assume that you place $100,000 into a five-year bank certificate of deposit that pays 3.1 percent in interest annually. That's the average CD rate as of Dec. 31, 2008, according to Bankrate.com. If you earn 3.1 percent, you earn $3,100 in interest. Of course, you don't get to keep all that money because the interest is taxable.
Let's assume that you pay both federal and state income taxes. Let's further assume that your combined federal/state tax bracket is 30 percent. Since the CD paid 3.1 percent, you lose 0.93 percent to taxes, leaving you with a profit of 2.17 percent.
But let's not forget inflation. If inflation is averaging 3.2 percent, you're actually losing 1.03 percent on every dollar you invested in that CD. Now, losing 1.03 percent annually might not seem like much, considering that the S&P 500 lost 38.5 percent in 2008. But the stock market doesn't lose every year, while the CD does.
If you lose 1.03 percent every year for 20 years, guess what happens? You end up losing 20.6 percent of your money. In other words, if you start with $100,000, over 20 years you'll watch your money "grow" to $79,400 in real economic terms.
That's what happens when you plop the bulk of your money into low-yielding investments. You'll most likely go broke, and you'll do it safely.