Saving for a future purchase is difficult today

I have a friend who saved some cash for the future. The problem is inflation. Hide $10,000 under your mattress and in five years it will have the buying power of $8,587.34 if inflation runs at as little as 3% annually.

Deposit the money in the bank and the interest paid helps to lessen the loss. But unless the interest paid is greater than the inflation rate, the buying power of the money still shrinks. It is tough protecting money from inflation. For many of us, it is impossible.

Which brings us to the stock market. Convert your savings into equities, stock, and, if you are lucky, when you cash out in five years you will have all your buying power intact plus a nice gain. If you are unlucky, and this may happen about a third of the time, you will will have vastly less money. It is not difficult to imagine a loss of 20% or more. A loss of 20% is so common that it even has a name: a bear market.

Clearly, the market often pays handsomely but it can also inflict great financial pain. The possibility of a handsome gain is the reward for taking on the risk. The aim of investing is to find ways to minimize risk while maximizing gain.

Does this mean one should stay clear of the stock market? For some folk, in a word, yes. If you cannot afford the loss, even temporarily, don't invest in the market. But if you are able to aim for a withdrawal window that spans a time frame up to three years, you simply do not sell your stock while the bear is roaming the market. You hold onto your stock, you enjoy the dividends if your stock pays dividends, and you wait until the bull market comes back. I like to plan for a three year recovery period.

Some important points to keep in mind when investing in the market:

• Buying stock is placing a bet on the health of our financial system.
• Investing in the market means you have converted your cash into stock. It is not money again till sold.
• The market is risky. Companies can and do go bankrupt. Losing all of one's investment is always a possibility. Think Northern Telecom or General Motors.

Remember the $10,000 placed under the mattress? It lost more than 14% of its buying power in five years. 

If that $10,000 had been converted to stock in the Bank of Nova Scotia five years ago, it might easily have gown to $11,362 today. Plus it paid a generous dividend greater than 4.5%. In total, one has more than $13,660 before factoring in inflation. 

If the market is down at the end of five years, one simply keeps the stock for up to three extra years and enjoys the extra dividends as the reward for patience.

It is worth noting that the top five Canadian banks have never cut their dividend. The Bank of Montreal is approaching 200 years without once missing its dividend payment. This is something to keep in mind when buying Canadian bank stock.